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209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 1 Insurance accounting under IFRS 1 Step one towards an international accounting standard on insurance The IASB issued IFRS 4 in March 2004 to provide interim guidance on accounting for insurance contracts. The Standard is the result of the first phase (phase I) of the IASB's project to develop an accounting standard to address the many complex and conceptual problems in insurance accounting. Before introduction of the Standard, IFRSs did not address specific insurance issues, while certain IFRSs specifically excluded insurance business. This resulted in diversity in the accounting practices of insurers. Given the need to create a stable platform of accounting standards by March 2004, due to mandatory application of IFRSs in many jurisdictions by 2005, the IASB developed IFRS 4 as an interim measure. It is expected that the Standard will not add significant costs to financial reporting that might become unnecessary once the more comprehensive project (phase II) is completed. The IASB has just begun phase II of the insurance contracts project and has established a new industry advisory group to assist them in this project. The main impact that IFRS 4 is expected to have is on classification of insurance contracts and disclosure in financial statements of entities issuing insurance contracts. The Standard has also brought about a number of changes in other IFRSs which will need to be addressed. Both existing IFRS reporters and first-time adopters should closely evaluate their current insurance contract accounting in relation to the requirements of IFRS 4. This publication provides an overview of IFRS 4 and selected sections of other IFRSs applicable to insurers. We hope this publication will be useful to you and your organisation while preparing to implement the requirements of IFRS 4. David B. Greenfield Global Sector Leader, Insurance KPMG LLP (US) © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 2 2 Insurance accounting under IFRS About this publication Content Information in this publication is current at 31 March 2004. It considers standards and interpretative guidance that were effective at 31 March 2004 and provides commentary on the likely impact of IFRS 4 and practical issues. Further interpretations of the Standard are likely to develop during the course of 2004 as companies work with their advisors to understand the requirements and implement them. IFRS 4 is applicable for annual periods beginning on or after 1 January 2005. Earlier application is however encouraged and where an entity applies the 1 Standard to an earlier period it should disclose that fact . This publication is mainly aimed at insurers and limited reference is made to insurance contracts issued by non-insurers. Organisation of the text Throughout this publication we have made reference to IFRS 4, the Implementation Guidance and Basis for Conclusions accompanying the Standard, as well as other current statements of IFRS. Direct quotations from IFRSs are included in dark blue within the text. A column noted as Reference is included in the left margin of Sections 1 through 15 to enable users to identify the relevant paragraphs of IFRS 4, the Interpretation Guidance and Basis for Conclusions as well as references to other applicable Standards. Reference to IFRSs made throughout the text are identified in an appendix to the publication. Examples are included throughout the text to elaborate or clarify the more complex principles of IFRS 4. These appear in shaded light blue boxes within the text. Footnotes have been included to further clarify issues, as appropriate. 1 It should be noted that the European Commission has at this stage not fully endorsed the application of IFRS 4 or IAS 39 and IAS 32, on financial instruments, for companies in the European Union. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 3 Insurance accounting under IFRS 3 Keep in contact and stay up–to–date IFRS 4 is intended to cover all entities that issue insurance contracts, not only insurance companies in the legal or regulatory sense. Further interpretation of the Implementation Guidance, Basis for Conclusions and IFRS 4 are required for an entity to apply the standard to its own facts, circumstances and individual transactions. Also, some of the information in this publication is based on interpretations of current literature, which may change as practice and implementation guidance continue to develop. Users are cautioned to read this publication in conjunction with the actual text of the Standard, Implementation Guidance and Basis for Conclusions and to consult their professional advisors before concluding on accounting treatments for their own transactions. This publication has been produced by KPMG’s Global Insurance Industry Group in association with KPMG’s IFR Group. For further information, please visit www.kpmg.co.uk/ifrs, where you will find up–to–date technical information and a briefing on KPMG's IFRS conversion resources. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 4 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 5 Insurance accounting under IFRS 5 Contents Step one towards an international accounting standard on insurance 1 About this publication 2 1. Purpose of the Standard 6 2. How do you identify an insurance contract? 8 3. How do you identify and account for embedded derivatives? 15 4. When do you unbundle a deposit component? 22 5. What does the exemption from IAS 8 mean? 26 6. Can you subsequently change an accounting policy? 28 7. How do you determine the sufficiency of insurance liabilities and assets? 32 8. How do you account for reinsurance? 37 9. How do you account for acquired insurance portfolios? 39 10. How do you account for discretionary participation features? 41 11. How do you account for non–insurance assets? 47 12. How do you deal with an ‘asset–liability mismatch’? 53 13. What do you disclose? 56 14. Accounting for investment contracts 64 15. Transition and implementation 73 IFRS references 77 © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 6 6 Insurance accounting under IFRS 1. Purpose of the Standard Key topics covered in this Section: • Objective of the Standard • Scope of the Standard Reference 1.1 Objective of the Standard IFRS 4.BC2–BC4 IFRS 4 Insurance Contracts was issued by the International Accounting Standards Board (IASB) on 31 March 2004 as the first step in the IASB’s project to achieve convergence of widely varying accounting practices in insurance industries around the world. IFRS 4.1 The objective of IFRS 4 is to: • achieve limited improvements in accounting for insurance contracts by 1 insurers ; and • introduce appropriate disclosure to identify and explain amounts in insurers’ financial statements arising from insurance contracts and to help users understand the amount, timing and uncertainty of future cash flows from insurance contracts. 1.2 Scope of the Standard IFRS 4.2–3 IFRS 4 applies to contracts in which an entity takes on insurance risk either as an insurer or a reinsurer. It also applies to contracts in which an entity cedes insurance risk to a reinsurer. The Standard does not address accounting and disclosure of direct insurance contracts in which the entity is the policyholder. (This will be addressed in Phase II of the IASB’s project.) IFRS 4 also addresses the treatment of certain financial instruments issued by an entity which allow the policyholder to participate in profits of the entity or investment returns on a specified pool of assets held by the entity through discretionary participation features. IFRS 4 specifically mentions that other aspects of accounting by insurers are not addressed by the standard, except for some transitional provisions relating to the redesignation of financial assets as at ‘fair value through profit or loss’. (Refer to chapter 11 for further discussion of accounting for non–insurance assets) This means that all other standards, including IAS 32 Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognition and Measurement are as applicable to insurers as they are to entities active in other industries. 1 An insurer is the party which accepts insurance risk under a contract, whether or not the entity is regarded as an insurer for legal or supervisory purposes. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 7 Insurance accounting under IFRS 7 IFRS 4.4 In addition, IFRS 4 scopes out the following transactions that may meet the definition of an insurance contract, but are already covered by other standards: • employers’ assets and liabilities under employee benefit plans (covered by IAS 19 Employee Benefits and IFRS 2 Share-based Payment) and retirement benefit obligations reported by defined benefit plans (covered by IAS 26 Accounting and Reporting by Retirement Benefit Plans); • financial guarantees that an entity enters into or retains on transferring financial assets or financial liabilities, within the scope of IAS 39, to another party – regardless of whether the financial guarantees are described as financial 2 guarantees, letters of credit or insurance contracts ; • product warranties issued directly by a manufacturer, dealer or retailer (see IAS 18 Revenue and IAS 37 Provisions, Contingent Liabilities and Contingent Assets); • contractual rights or contractual obligations that are contingent on the future use of, or right to use, a non-financial item (for example, some licence fees, royalties, contingent lease payments and similar items), as well as a lessee’s residual value guarantee embedded in a finance lease (see IAS 17 Leases, IAS 18 Revenue and IAS 38 Intangible Assets); and • contingent consideration payable or receivable in a business combination (see IFRS 3 Business Combinations). The applicability of IFRS 4 to the parties to insurance contracts Contracts Policyholder transferring Insurer insurance risk Contracts transferring insurance risk Reinsurer Does not apply IFRS 4 to the contract Applies IFRS 4 to both contracts Applies IFRS 4 to both contracts X

Contracts transferring insurance risk Reinsurer Applies IFRS 4 to the contract
Source: KPMG International, 2004 2 The IASB published an Exposure Draft in July 2004 which proposes that all financial guarantees be accounted for as prescribed in IAS 39 even if they meet the definition of an insurance contract. The Exposure Draft is open for comment until 8 October 2004. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 8 8 Insurance accounting under IFRS 2. How do you identify an insurance contract? Key topics covered in this Section: Reference 2.1 • Definition of an insurance contract • Definition of insurance risk • Further guidance regarding insurance risk • Special issues Definition of an insurance contract IFRS 4 provides a new definition of insurance contracts. This replaces definitions used in other IFRSs which exclude insurance business from their scope. Appendix A to IFRS 4 An insurance contract is a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. 2.2 Appendix A to IFRS 4 IFRS 4.C6 Definition of insurance risk The conceptual basis of an insurance contract is the presence of significant insurance risk. Insurance risk is defined as a transferred risk other than financial risk. Financial risk is defined in terms of changes in the same variables used in the 1 definition of a derivative in IAS 39 . With the introduction of IFRS 4, the definition of financial risk was amended in IFRSs to include non–financial variables which are not specific to one of the parties of the contract. IFRS 4.IG2, Examples 1.15 and 1.19 Examples of non–financial variables not specific to a party to the contract and therefore included in the definition of financial risk IAS 39.AG12A • Weather or catastrophe indices such as an index of temperatures in a particular city or an index of earthquake losses in a particular region; • Mortality rates of a population; • Claims indices of an insurance market; • Changes in the fair value of a non–financial asset reflecting the change in market prices for such assets. 1 Financial risks include the risk of a possible change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 9 Insurance accounting under IFRS 9 IFRS 4.IG2, Examples 1.15 Examples of non–financial variables specific to a party to the contract and therefore excluded from the definition of financial risk • The claims index, cost or lapse rate of that party; • The state of health of the party; or • A change in the condition of an asset that the party owns. IFRS 4. B12–B16 and B24(a)–(b) The requirement that insurance risk is always transferred risk, means that only risks accepted by the insurer, which were pre–existing for the policyholder at the inception of the contract, meet the definition of insurance risk. Lapse, persistency or expense risks, resulting from contracts written, do not constitute insurance risk as they are not transferred risks – even if these risks are triggered by the same events that trigger insurance risk. It therefore follows that the loss of future earnings for the insurer, when the contract is terminated by the insured event, is not insurance risk as the economic loss for the insurer is not a transferred risk. Also, the waiver on death of charges that would be made on cancellation or surrender does not compensate the policyholder for a pre–exisiting risk and is therefore not an insurance risk. However, the transfer of these risks to another party through a second contract, gives rise to insurance risk for that party. IFRS 4.BC33 IFRS 4 does not provide quantitative guidance for assessing the significance of insurance risk, because the IASB felt that creating an arbitrary dividing line would result in different accounting treatments for similar transactions that fall marginally on different sides of the line. IFRS 4.B23 When assessing the significance of insurance risk two factors should be considered. The insured event should have a sufficient probability of occurrence and a sufficient magnitude of effect. The probability and the magnitude are measured independently to determine the significance of the insurance risk. The occurrence of an event is viewed as sufficiently probable if the occurrence thereof has commercial substance. Any event, which policyholders see as a threat to their economic position and for which they are willing to pay for cover, has commercial substance. Therefore even if its occurrence is considered unlikely this is considered to be sufficient. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved. 209-385 IFRS 4 Practitioners guide (admended final from printer).qxd 11/8/2004 9:56 AM Page 10 10 Insurance accounting under IFRS Following the same logic, the magnitude of the effect of an event is considered sufficient if the effect on the policyholder is significant when compared to the minimum benefits payable in a scenario of commercial substance. IFRS 4.B13 Payments made which do not compensate the policyholder for the effect of the insured event, e.g. payments made for competitive reasons, are not taken into consideration in the assessment of insurance risk. However, IFRS 4 does not limit the payment by the insurer to an amount equal to the financial impact of the adverse event. The definition therefore does not exclude ‘new–for–old’ cover that pays the policyholder an amount sufficient to replace the old asset and does not limit payment under term life cover to the financial loss suffered by the deceased’s dependants. IFRS 4.B25 2 The significance of insurance risk is measured at contract level without considering the risk exposure of the entire portfolio. Therefore, the effect of risk equalisation in the portfolio is ignored. However, IFRS 4 provides that where a portfolio of homogenous contracts are known to generally contain significant insurance risk, each contract can be treated as an insurance contract, without applying the requirement to assess the significance of insurance risk to each individual contract. Example of a portfolio of homogenous contracts – treated as insurance but which may include a few contracts which do not transfer significant insurance risk IFRS 4.IG2, Example 1.5 The significance of insurance risk in endowment contracts typically depends on the age of the policyholder at the outset of the contract or on the contract duration. Where insurance risk is known to generally be significant based on these factors, the few contracts with an unusually low entry age or unusually short duration, forming part of a portfolio of endowment contracts, need not be considered separately. 2.3 Further guidance regarding insurance risk IFRS 4 provides further guidance on the term ‘insurance risk’ as used in the definition of an insurance contract. The transfer of risk, in the form of a specified uncertain future event that could have an adverse affect on the policyholder if it occurs, takes place by agreeing the compensation to be paid on realisation of that risk. 2 For this purpose, contracts entered into simultaneously with a single counterparty form a single contract. © 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International provides no services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. 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