IFRS 4 Basis For Conclusions

March 2004
Basis for Conclusions

IFRS 4
BASIS FOR CONCLUSIONS ON INTERNATIONAL FINANCIAL REPORTING STANDARD
IFRS 4 Insurance Contracts
International Accounting Standards Board
Basis for Conclusions on
IFRS 4 Insurance Contracts
IFRS 4 INSURANCE CONTRACTS
This Basis for Conclusions accompanies IFRS 4 Insurance Contracts (see separate booklet) and is published by the International Accounting Standards Board, 30 Cannon Street, London EC4M 6XH, United Kingdom. Tel: +44 (0)20 7246 6410 Fax: +44 (0)20 7246 6411 Email: iasb@iasb.org Web: www.iasb.org The IASB, the IASCF, the authors and the publishers do not accept responsibility for loss caused to any person who acts or refrains from acting in reliance on the material in this publication, whether such loss is caused by negligence or otherwise. ISBN for this part: 1-904230-51-2 ISBN for complete publication (three parts): 1-904230-49-0 Copyright 2004 International Accounting Standards Committee Foundation (IASCF) International Financial Reporting Standards (including International Accounting Standards and SIC and IFRIC Interpretations), Exposure Drafts, and other IASB publications are copyright of the International Accounting Standards Committee Foundation (IASCF). The approved text of International Financial Reporting Standards and other IASB publications is that published by the IASB in the English language and copies may be obtained from the IASCF. Please address publications and copyright matters to: IASCF Publications Department, 1st Floor, 30 Cannon Street, London EC4M 6XH, United Kingdom. Tel: +44 (0)20 7332 2730 Fax: +44 (0)20 7332 2749 Email: publications@iasb.org Web: www.iasb.org All rights reserved. No part of this publication may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system, without prior permission in writing from the International Accounting Standards Committee Foundation.
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IFRS 4 BASIS FOR CONCLUSIONS MARCH 2004
Contents Basis for Conclusions IFRS 4 Insurance Contracts

paragraphs INTRODUCTION Background Tentative conclusions for phase II SCOPE Definition of insurance contract Insurance risk Insurable interest Quantity of insurance risk Expiry of insurance-contingent rights and obligations Unbundling Weather derivatives Scope exclusions Financial guarantees and insurance against credit risk Product warranties Accounting by policyholders Prepaid service contracts TEMPORARY EXEMPTION FROM SOME OTHER IFRSs Catastrophe and equalisation provisions Liability adequacy Derecognition Offsetting Reinsurance assets Impairment of reinsurance assets Gains and losses on buying reinsurance Other existing practices Acquisition costs Salvage and subrogation BC1-BC9 BC2-BC5 BC6-BC9 BC10-BC76 BC11-BC60 BC21-BC24 BC25-BC29 BC30-BC37 BC38-BC39 BC40-BC54 BC55-BC60 BC61-BC76 BC62-BC68 BC69-BC72 BC73 BC74-BC76 BC77-BC122 BC87-BC93 BC94-BC104 BC105 BC106 BC107-BC114 BC107-BC108 BC109-BC114 BC115-BC122 BC116-BC119 BC120-BC121
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Policy loans CHANGES IN ACCOUNTING POLICIES Relevance and reliability Discounting Investment management fees Uniform accounting policies on consolidation Excessive prudence Future investment margins Future investment margins and embedded value Redesignation of financial assets ACQUISITION OF INSURANCE CONTRACTS IN BUSINESS COMBINATIONS AND PORTFOLIO TRANSFERS DISCRETIONARY PARTICIPATION FEATURES ISSUES RELATED TO IAS 39 Assets held to back insurance contracts Shadow accounting Investment contracts Embedded derivatives Elimination of internal items INCOME TAXES DISCLOSURE Materiality Explanation of recognised amounts Assumptions Changes in insurance liabilities Amount, timing and uncertainty of cash flows Insurance risk Sensitivity analysis Claims development Probable maximum loss Exposures to interest rate risk or market risk
BC122 BC123-BC146 BC123-BC125 BC126-BC127 BC128-BC130 BC131-BC132 BC133 BC134-BC144 BC138-BC144 BC145-BC146
BC147-BC153 BC154-BC165 BC166-BC197 BC166-BC180 BC181-BC184 BC185-BC187 BC188-BC194 BC195-BC197 BC198 BC199-BC226 BC208-BC210 BC211-BC214 BC211-BC213 BC214 BC215-BC223 BC217 BC218-BC219 BC220-BC221 BC222 BC223
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Fair value of insurance liabilities and insurance assets SUMMARY OF CHANGES FROM ED 5 DISSENTING OPINIONS
BC224-BC226 BC227 DO1-DO20
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Basis for Conclusions on IFRS 4 Insurance Contracts

This Basis for Conclusions accompanies, but is not part of, IFRS 4.
INTRODUCTION
BC1 This Basis for Conclusions summarises the International Accounting Standards Boards considerations in reaching the conclusions in IFRS 4 Insurance Contracts. Individual Board members gave greater weight to some factors than to others.
Background
BC2 The Board decided to develop an International Financial Reporting Standard (IFRS) on insurance contracts because: (a) there was no IFRS on insurance contracts, and insurance contracts were excluded from the scope of existing IFRSs that would otherwise have been relevant (eg IFRSs on provisions, financial instruments, intangible assets). (b) accounting practices for insurance contracts were diverse, and also often differed from practices in other sectors. BC3 The Boards predecessor organisation, the International Accounting Standards Committee (IASC), set up a Steering Committee in 1997 to carry out the initial work on this project. In December 1999, the Steering Committee published an Issues Paper, which attracted 138 comment letters. The Steering Committee reviewed the comment letters and concluded its work by developing a report to the Board in the form of a Draft Statement of Principles (DSOP). The Board started discussing the DSOP in November 2001. The Board did not approve the DSOP or invite formal comments on it, but made it available to the public on the IASBs Website. Few insurers report using IFRSs at present, although many more are expected to do so from 2005. Because it was not feasible to complete this project for implementation in 2005, the Board split the project into two phases so that insurers could implement some aspects in 2005. The Board published its proposals for phase I in July 2003 as ED 5 Insurance
BC4
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Contracts. The deadline for comments was 31 October 2003 and the Board received 135 responses. After reviewing the responses, the Board issued IFRS 4 in March 2004. BC5 The Boards objectives for phase I were: (a) to make limited improvements to accounting practices for insurance contracts, without requiring major changes that may need to be reversed in phase II. (b) to require disclosure that (i) identifies and explains the amounts in an insurers financial statements arising from insurance contracts and (ii) helps users of those financial statements understand the amount, timing and uncertainty of future cash flows from insurance contracts.
Tentative conclusions for phase II

BC6 The Board sees phase I as a stepping stone to phase II and is committed to completing phase II without delay once it has investigated all relevant conceptual and practical questions and completed its due process. In January 2003, the Board reached the following tentative conclusions for phase II: (a) The approach should be an asset-and-liability approach that would require an entity to identify and measure directly the contractual rights and obligations arising from insurance contracts, rather than create deferrals of inflows and outflows. (b) Assets and liabilities arising from insurance contracts should be measured at their fair value, with the following two caveats: (i) Recognising the lack of market transactions, an entity may use entity-specific assumptions and information when market-based information is not available without undue cost and effort. In the absence of market evidence to the contrary, the estimated fair value of an insurance liability shall not be less, but may be more, than the entity would charge to accept new contracts with identical contractual terms and remaining maturity from new policyholders. It follows that an insurer would not recognise a net gain at inception of an insurance contract, unless such market evidence is available.
(ii)
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(c) As implied by the definition of fair value: (i) (ii) an undiscounted measure is inconsistent with fair value. expectations about the performance of assets should not be incorporated into the measurement of an insurance contract, directly or indirectly (unless the amounts payable to a policyholder depend on the performance of specific assets). the measurement of fair value should include an adjustment for the premium that marketplace participants would demand for risks and mark-up in addition to the expected cash flows. fair value measurement of an insurance contract should reflect the credit characteristics of that contract, including the effect of policyholder protections and insurance provided by governmental bodies or other guarantors.
(iii)
(iv)
(d) The measurement of contractual rights and obligations associated with the closed book of insurance contracts should include future premiums specified in the contracts (and claims, benefits, expenses, and other additional cash flows resulting from those premiums) if, and only if: (i) policyholders hold non-cancellable continuation or renewal rights that significantly constrain the insurers ability to reprice the contract to rates that would apply for new policyholders whose characteristics are similar to those of the existing policyholders; and those rights will lapse if the policyholders stop paying premiums.
(ii)
(e) Acquisition costs should be recognised as an expense when incurred. (f) The Board will consider two more questions later in phase II: (i) Should the measurement model unbundle the individual elements of an insurance contract and measure them individually? How should an insurer measure its liability to holders of participating contracts?
(ii)
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BC7
In two areas, those tentative conclusions differ from the IASC Steering Committees recommendations in the DSOP: (a) the use of a fair value measurement objective rather than entity-specific value. However, that change is not as significant as it might seem because entity-specific value as described in the DSOP is indistinguishable in most respects from estimates of fair value determined using measurement guidance that the Board has tentatively adopted in phase II of its project on business combinations. (b) the criteria used to determine whether measurement should reflect future premiums and related cash flows (paragraph BC6(d)).
BC8
Since January 2003, constraints on Board and staff resources have prevented the Board from continuing work to determine whether its tentative conclusions for phase II can be developed into a standard that is consistent with the IASB Framework and workable in practice. The Board intends to return to phase II of the project in the second quarter of 2004. It plans to focus at that time on both conceptual and practical issues, as in any project. Only after completing its deliberations will the Board proceed with an Exposure Draft of a proposed IFRS. The Boards deliberations in all projects include a consideration of alternatives and whether those alternatives represent conceptually superior approaches to financial reporting issues. Consequently, the Board will examine existing practices throughout the world to ascertain whether any could be deemed to be a superior answer suitable for international adoption. As discussed in paragraph BC84, ED 5 proposed a sunset clause, which the Board deleted in finalising the IFRS. Although respondents generally opposed the sunset clause, many applauded the Boards signal of its commitment to complete phase II without delay.
BC9
SCOPE
BC10 Some argued that the IFRS should deal with all aspects of financial reporting by insurers, to ensure that the financial reporting for insurers is internally consistent. They noted that regulatory requirements, and some national accounting requirements, often cover all aspects of an insurers business. However, for the following reasons, the IFRS deals with insurance contracts of all entities and does not address other aspects of accounting by insurers:
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(a) It would be difficult, and perhaps impossible, to create a robust definition of an insurer that could be applied consistently from country to country. Among other things, an increasing number of entities have major activities in both insurance and other areas. (b) It would be undesirable for an insurer to account for a transaction in one way and for a non-insurer to account in a different way for the same transaction. (c) The project should not reopen issues addressed by other IFRSs, unless specific features of insurance contracts justify a different treatment. Paragraphs BC166-BC180 discuss the treatment of assets backing insurance contracts.
Definition of insurance contract

BC11 The definition of an insurance contract determines which contracts are within the scope of IFRS 4 rather than other IFRSs. Some argued that phase I should use existing national definitions of insurance contracts, on the following grounds: (a) Before phase II gives guidance on applying IAS 39 Financial Instruments: Recognition and Measurement to difficult areas such as discretionary participation features and cancellation and renewal rights, it would be premature to require insurers to apply IAS 39 to contracts that contain these features and rights. (b) The definition adopted for phase I may need to be amended again for phase II. This could compel insurers to make extensive changes twice in a short time. BC12 However, in the Boards view, it is unsatisfactory to base the definition used in IFRSs on local definitions that may vary from country to country and may not be most relevant for deciding which IFRS ought to apply to a particular type of contract. Some expressed concerns that the adoption of a particular definition by the IASB could lead ultimately to inappropriate changes in definitions used for other purposes, such as insurance law, insurance supervision or tax. The Board emphasises that any definition used in IFRSs is solely for financial reporting and is not intended to change or pre-empt definitions used for other purposes. Various Standards issued by IASC used definitions or descriptions of insurance contracts to exclude insurance contracts from their scope. The scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets
BC13
BC14
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and of IAS 38 Intangible Assets excluded provisions, contingent liabilities, contingent assets and intangible assets that arise in insurance enterprises from contracts with policyholders. IASC used this wording when its insurance project had just started, to avoid prejudging whether the project would address insurance contracts or a broader class of contracts. Similarly, the scope of IAS 18 Revenue excluded revenue arising from insurance contracts of insurance enterprises. BC15 The following definition of insurance contracts was used to exclude insurance contracts from the scope of an earlier version of IAS 32 Financial Instruments: Disclosure and Presentation and IAS 39.
An insurance contract is a contract that exposes the insurer to identified risks of loss from events or circumstances occurring or discovered within a specified period, including death (in the case of an annuity, the survival of the annuitant), sickness, disability, property damage, injury to others and business interruption.
BC16
This definition was supplemented by a statement that IAS 32 and IAS 39 did, nevertheless, apply when a financial instrument takes the form of an insurance contract but principally involves the transfer of financial risks. For the following reasons, the Board discarded the previous definition in IAS 32 and IAS 39: (a) The definition gave a list of examples, but did not define the characteristics of the risks that it was intended to include. (b) A clearer definition reduces the uncertainty about the meaning of the phrase principally involves the transfer of financial risks. This will help insurers adopting IFRSs for the first-time (first-time adopters) in 2005 and minimises the likelihood of further changes in classification for phase II. Furthermore, the previous test could have led to many contracts being classified as financial instruments even though they transfer significant insurance risk.
BC17
BC18
In developing a new definition, the Board also considered US GAAP. The main FASB statements for insurers deal with financial reporting by insurance entities and do not define insurance contracts explicitly. However, paragraph 1 of SFAS 113 Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts states:
Insurance provides indemnification against loss or liability from specified events and circumstances that may occur or be discovered during a specified period. In exchange for a payment from the policyholder (a premium), an insurance enterprise agrees to pay the policyholder if specified events occur or are discovered.
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BC19
Paragraph 6 of SFAS 113 applies to any transaction, regardless of its form, that indemnifies an insurer against loss or liability relating to insurance risk. The glossary appended to SFAS 113 defines insurance risk as:
The risk arising from uncertainties about both (a) the ultimate amount of net cash flows from premiums, commissions, claims, and claim settlement expenses paid under a contract (often referred to as underwriting risk) and (b) the timing of the receipt and payment of those cash flows (often referred to as timing risk). Actual or imputed investment returns are not an element of insurance risk. Insurance risk is fortuitousthe possibility of adverse events occurring is outside the control of the insured.
BC20
Having reviewed these definitions from US GAAP, the Board developed a new definition of insurance contract for the IFRS and expects to use the same definition for phase II. The following aspects of the definition are discussed below: (a) insurance risk (paragraphs BC21-BC24); (b) insurable interest (paragraphs BC25-BC29); (c) quantity of insurance risk (paragraphs BC30-BC37); (d) expiry of insurance-contingent rights and obligations (paragraphs BC38 and BC39); (e) unbundling (paragraphs BC40-BC54); and (f) weather derivatives (paragraphs BC55-BC60).
Insurance risk
BC21 The definition of an insurance contract in the IFRS focuses on the feature that causes accounting problems unique to insurance contracts, namely insurance risk. The definition of insurance risk excludes financial risk, defined using a list of risks that also appears in IAS 39s definition of a derivative. Some contracts have the legal form of insurance contracts but do not transfer significant insurance risk to the issuer. Some argue that all such contracts should be treated as insurance contracts, for the following reasons: (a) These contracts are traditionally described as insurance contracts and are generally subject to regulation by insurance supervisors.
BC22
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(b) Phase I will not achieve great comparability between insurers because it will permit a diverse range of treatments for insurance contracts. It would be preferable to ensure consistency at least within a single insurer. (c) Accounting for some contracts under IAS 39 and others under local GAAP is unhelpful to users. Moreover, some argued that IAS 39 contains insufficient, and possibly inappropriate, guidance for investment contracts.* (d) The guidance proposed in ED 5 on significant insurance risk was too vague, would be applied inconsistently and relied on actuarial resources in short supply in many countries. BC23 However, as explained in the Framework, financial statements should reflect economic substance and not merely legal form. Furthermore, accounting arbitrage could occur if the addition of an insignificant amount of insurance risk made a significant difference to the accounting. Therefore, the Board decided that contracts described in the previous paragraph should not be treated as insurance contracts for financial reporting. Some respondents suggested that an insurance contract is any contract under which the policyholder exchanges a fixed amount (ie the premium) for an amount payable if an insured event occurs. However, not all insurance contracts have explicit premiums (eg insurance cover bundled with some credit card contracts). Adding a reference to premiums would have introduced no more clarity and might have required more supporting guidance and explanations.
BC24
Insurable interest
BC25 In some countries, the legal definition of insurance requires that the policyholder or other beneficiary should have an insurable interest in the insured event. For the following reasons, the definition proposed in 1999 by the former IASC Steering Committee in the Issues Paper did not refer to insurable interest: (a) Insurable interest is defined in different ways in different countries. Also, it is difficult to find a simple definition of insurable interest that is adequate for such different types of insurance as insurance against fire, term life insurance and annuities.
* Investment contract is an informal term referring to a contract issued by an insurer that does not expose the insurer to significant insurance risk and is therefore within the scope of IAS 39.
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(b) Contracts that require payment if a specified uncertain future event occurs cause similar types of economic exposure, whether or not the other party has an insurable interest. BC26 Because the definition proposed in the Issues Paper did not include a notion of insurable interest, it would have encompassed gambling. Several commentators on the Issues Paper stressed the important social, moral, legal and regulatory differences between insurance and gambling. They noted that policyholders buy insurance to reduce risk, whereas gamblers take on risk (unless they use a gambling contract as a hedge). In the light of these comments, the definition of an insurance contract in the IFRS incorporates the notion of insurable interest. Specifically, it refers to the fact that the insurer accepts risk from the policyholder by agreeing to compensate the policyholder if an uncertain event adversely affects the policyholder. The notion of insurable interest also appears in the definition of financial risk, which refers to a non-financial variable not specific to a party to the contract. This reference to an adverse effect is open to the objections set out in paragraph BC25. However, without this reference, the definition of an insurance contract might have captured any prepaid contract to provide services whose cost is uncertain (see paragraphs BC74-BC76 for further discussion). This would have extended the meaning of the term insurance contract too far beyond its traditional meaning. Some respondents to ED 5 were opposed to including the notion of insurable interest, on the following grounds: (a) In life insurance, there is no direct link between the adverse event and the financial loss to the policyholder. Moreover, it is not clear that survival adversely affects an annuitant. Any contract that is contingent on human life should meet the definition of insurance contract. (b) This notion excludes some contracts that are, in substance, used as insurance, such as weather derivatives (see paragraphs BC55BC60 for further discussion). The test should be whether there is a reasonable expectation of some indemnification to policyholders. A tradable contract could be brought within the scope of IAS 39. (c) It would be preferable to eliminate the notion of insurable interest and replace it with the notion that insurance is a business that involves assembling risks into a pool that is managed together. BC29 The Board decided to retain the notion of insurable interest because it gives a principle-based distinction, particularly between insurance contracts and other contracts that happen to be used for hedging.
BC27
BC28
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Furthermore, it is preferable to base a distinction on the type of contract, rather than the way an entity manages a contract or group of contracts. Moreover, the Board decided that it was unnecessary to refine this notion for a life insurance contract or life-contingent annuity, because such contracts typically provide for a predetermined amount to quantify the adverse effect (see paragraph B13 of the IFRS).
Quantity of insurance risk

BC30 Paragraphs B22-B28 of Appendix B of the IFRS discuss how much insurance risk must be present before a contract qualifies as an insurance contract. In developing this material, the Board noted the conditions in US GAAP for a contract to be treated as an insurance contract. SFAS 113 requires two conditions for a contract to be eligible for reinsurance accounting, rather than deposit accounting: (a) the contract transfers significant insurance risk from the cedant to the reinsurer (which does not occur if the probability of a significant variation in either the amount or timing of payments by the reinsurer is remote); and (b) either: (i) there is a reasonable possibility that the reinsurer will suffer a significant loss (based on the present value of all cash flows between the ceding and assuming enterprises under reasonably possible outcomes); or the reinsurer has assumed substantially all of the insurance risk relating to the reinsured portions of the underlying insurance contracts (and the cedant has retained only insignificant insurance risk on the reinsured portions).
(ii)
BC31
Under paragraph 8 of SFAS 97 Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, an annuity contract is considered an insurance contract unless (a) the probability that life contingent payments will be made is remote* or (b) the present value of the expected life-contingent payments relative to the present value of all expected payments under the contract is insignificant.
Paragraph 8 of SFAS 97 notes that the term remote is defined in paragraph 3 of SFAS 5 Accounting for Contingencies as the chance of the future event or events occurring is slight.
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BC32
The Board noted that some practitioners use the following guideline in applying US GAAP: a reasonable possibility of a significant loss is a 10 per cent probability of a 10 per cent loss. In this light, the Board considered whether it should define the amount of insurance risk in quantitative terms in relation to, for example: (a) the probability that payments under the contract will exceed the expected (ie probability-weighted average) level of payments; or (b) a measure of the range of outcomes, such as the range between the highest and lowest level of payments or the standard deviation of payments.
BC33
Quantitative guidance creates an arbitrary dividing line that results in different accounting treatments for similar transactions that fall marginally on different sides of the line. It also creates opportunities for accounting arbitrage by encouraging transactions that fall marginally on one side or the other of the line. For these reasons, the IFRS does not include quantitative guidance. The Board also considered whether it should define the significance of insurance risk by referring to materiality, which the Framework describes as follows. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. However, a single contract, or even a single book of similar contracts, could rarely generate a loss that is material in relation to the financial statements as a whole. Therefore, the IFRS defines the significance of insurance risk in relation to the individual contract (paragraph B25). The Board had two reasons for this: (a) Although insurers manage contracts on a portfolio basis, and often measure them on that basis, the contractual rights and obligations arise from individual contracts. (b) An assessment contract by contract is likely to increase the proportion of contracts that qualify as insurance contracts. If a relatively homogeneous book of contracts is known to consist of contracts that all transfer insurance risk, the Board did not intend to require insurers to examine each contract within that book to identify a few non-derivative contracts that transfer insignificant insurance risk (paragraph B25 of the IFRS). The Board intended to make it easier, not harder, for a contract to meet the definition.
BC34
BC35
The Board also rejected the notion of defining the significance of insurance risk by expressing the expected (ie probability-weighted) average of the present values of the adverse outcomes as a proportion of the expected present value of all outcomes, or as a proportion of the
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premium. This notion had some intuitive appeal because it would consider both amount and probability. However, it would have meant that a contract could start as an investment contract (ie a financial liability) and become an insurance contract as time passes or probabilities are reassessed. In the Boards view, requiring continuous monitoring over the life of the contract would be too onerous. Instead, the Board adopted an approach that requires this decision to be made once only, at the inception of a contract. The guidance in paragraphs B22-B28 of the IFRS focuses on whether insured events could cause an insurer to pay additional amounts, judged contract by contract. BC36 Some respondents objected to ED 5s proposal that insurance risk would be significant if a single plausible event could cause a loss that is more than trivial. They suggested that such a broad notion of significant insurance risk might permit abuse. Instead, they suggested referring to a reasonable possibility of a significant loss. However, the Board rejected this suggestion because it would have required insurers to monitor the level of insurance risk continually, which could have given rise to frequent reclassifications. It might also have been too difficult to apply this notion to remote catastrophic scenarios; indeed, some respondents asked the Board to clarify whether the assessment should include such scenarios. In finalising the IFRS, the Board clarified the terminology by (a) replacing the notion of a plausible scenario with an explanation of the need to ignore scenarios that have no commercial substance and (b) replacing the term trivial with the term insignificant. Some respondents asked the Board to clarify the basis of comparison for the significance test, because of uncertainty about the meaning of the phrase net cash flows arising from the contract in ED 5. Some suggested that this would require a comparison with the profit that the issuer expects from the contract. However, the Board had not intended this reading, which would have led to the absurd conclusion that any contract with a profitability of close to zero might qualify as an insurance contract. In finalising the IFRS, the Board confirmed in paragraphs B22-B28 that: (a) the comparison is between the amounts payable if an insured event occurs and the amounts payable if no insured event occurs. Implementation Guidance in IG Example 1.3 addresses a contract in which the death benefit in a unit-linked contract is 101 per cent of the unit value.
BC37
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(b) surrender charges that might be waived on death are not relevant in assessing how much insurance risk a contract transfers because their waiver does not compensate the policyholder for a pre-existing risk. Implementation Guidance in IG Examples 1.23 and 1.24 is relevant.
Expiry of insurance-contingent rights and obligations

BC38 Some respondents suggested that a contract should no longer be treated as an insurance contract after all insurance-contingent rights and obligations have expired. However, this suggestion could have required insurers to set up new systems to identify these contracts. Therefore, paragraph B30 states that an insurance contract remains an insurance contract until all rights and obligations expire. IG Example 2.19 in the Implementation Guidance addresses dual-trigger contracts. Some respondents suggested that a contract should not be regarded as an insurance contract if the insurance-contingent rights and obligations expire after a very short time. The IFRS includes material that may be relevant: paragraph B23 explains the need to ignore scenarios that lack commercial substance and paragraph B24(b) notes that there is no significant transfer of pre-existing risk in some contracts that waive surrender penalties on death.
BC39
Unbundling
BC40 The definition of an insurance contact distinguishes insurance contracts within the scope of the IFRS from investments and deposits within the scope of IAS 39. However, many insurance contracts contain a significant deposit component (ie a component that would, if it were a separate instrument, be within the scope of IAS 39). Indeed, virtually all insurance contracts have an implicit or explicit deposit component, because the policyholder is generally required to pay premiums before the period of risk; therefore, the time value of money is likely to be one factor that insurers consider in pricing contracts. To reduce the need for guidance on the definition of an insurance contract, some argue that an insurer should unbundle the deposit component from the insurance component. Unbundling has the following consequences: (a) The insurance component is measured as an insurance contract.
BC41
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(b) The deposit component is measured under IAS 39 at either amortised cost or fair value. This might not be consistent with the basis used for insurance contracts. (c) Premium receipts for the deposit component are recognised not as revenue, but rather as changes in the deposit liability. Premium receipts for the insurance element are typically recognised as revenue. (d) A portion of the transaction costs incurred at inception is allocated to the deposit component if this allocation has a material effect. BC42 Supporters of unbundling deposit components argue that: (a) an entity should account in the same way for the deposit component of an insurance contract as for an otherwise identical financial instrument that does not transfer significant insurance risk. (b) the tendency in some countries for banks to own insurers (and vice versa) and the similarity of products offered by the insurance and fund management sectors suggest that insurers, banks and fund managers should account for the deposit component in a similar manner. (c) many groups sell products ranging from pure investments to pure insurance, with all variations in between. Unbundling would avoid sharp discontinuities in the accounting between a product that transfers just enough insurance risk to be an insurance contract, and another product that falls marginally on the other side of the line. (d) financial statements should make a clear distinction between premium revenue derived from products that transfer significant insurance risk and premium receipts that are, in substance, investment or deposit receipts. BC43 The Issues Paper published in 1999 proposed that the deposit component should be unbundled if it is either disclosed explicitly to the policyholder or clearly identifiable from the terms of the contract. However, commentators on the Issues Paper generally opposed unbundling, giving the following reasons: (a) The components are closely interrelated and the value of the bundled product is not necessarily equal to the sum of the individual values of the components. (b) Unbundling would require significant and costly systems changes.
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(c) Contracts of this kind are a single product, regulated as insurance business by insurance supervisors and should be treated in a similar way for financial reporting. (d) Some users of financial statements would prefer that either all products are unbundled or no products are unbundled, because they regard information about gross premium inflows as important. A consistent use of a single measurement basis might be more useful as an aid to economic decisions than mixing one measurement basis for the deposit component with another measurement basis for the insurance component. BC44 In the light of these arguments, the DSOP proposed that an insurer or policyholder should not unbundle these components. However, that was against the background of an assumption that the treatments of the two components would be reasonably similar. This may not be the case in phase I, because phase I permits a wide range of accounting treatments for insurance components. Nevertheless, the Board did not wish to require costly changes in phase I that might be reversed in phase II. Therefore, the Board decided to require unbundling only when it is easiest to perform and the effect is likely to be greatest (paragraphs 10-12 of the IFRS and IG Example 3 in the Implementation Guidance). The Board acknowledges that there is no clear conceptual line between the cases when unbundling is required and the cases when unbundling is not required. At one extreme, the Board regards unbundling as appropriate for large customised contracts, such as some financial reinsurance contracts, if a failure to unbundle them could lead to the complete omission from the balance sheet of material contractual rights and obligations. This may be especially important if a contract was deliberately structured to achieve a specific accounting result. Furthermore, the practical problems cited in paragraph BC43 are much less significant for these contracts. At the other extreme, unbundling the surrender values in a large portfolio of traditional life insurance contracts would require significant systems changes beyond the intended scope of phase I. Furthermore, failing to unbundle these contracts would affect the measurement of these liabilities, but not lead to their complete omission from the insurers balance sheet. In addition, a desire to achieve a particular accounting result is much less likely to influence the precise structure of these transactions. The option for the policyholder to surrender a traditional life insurance contract at an amount that differs significantly from its carrying amount is an embedded derivative and IAS 39 would require the insurer to separate
BC45
BC46
BC47
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it and measure it at fair value. That treatment would have the same disadvantages, described in the previous paragraph, as unbundling the surrender value. Therefore, paragraph 8 of the IFRS exempts an insurer from applying this requirement to some surrender options embedded in insurance contracts. However, the Board saw no conceptual or practical reason to create such an exemption for surrender options in non-insurance financial instruments issued by insurers or by others. BC48 Some respondents opposed unbundling in phase I on the following grounds, in addition to the reasons given in paragraph BC43: (a) Insurance contracts are, in general, designed, priced and managed as packages of benefits. Furthermore, the insurer cannot unilaterally terminate the agreement or sell parts of it. In consequence, any unbundling required solely for accounting would be artificial. Insurance contracts should not be unbundled unless the structure of the contract is clearly artificial. (b) Unbundling may require extensive systems changes that would increase the administrative burden for 2005 and not be needed for phase II. (c) There would be no need to require unbundling if the Board strengthened the liability adequacy test, defined significant insurance risk more narrowly and confirmed that contracts combined artificially are separate contracts. (d) The unbundling conditions in ED 5 were vague and did not explain the underlying principle. (e) Because ED 5 did not propose recognition criteria, insurers would use local GAAP to judge whether assets and liabilities were omitted. This would defeat the stated reason for unbundling. (f) If a contract is unbundled, the premium for the deposit component is recognised not as premium revenue but as a balance sheet movement (ie as a deposit receipt). Requiring this would be premature before the Board completes its project on reporting comprehensive income.
BC49
Some suggested other criteria for unbundling: (a) All contracts should be unbundled, or unbundling should always be permitted at least. Unbundling is required in Australia and New Zealand. (b) All non-insurance components (for example, service components) should be unbundled, not only deposit components.
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(c) Unbundling should be required only when the components are completely separable, or when there is an account in the name of the policyholder. (d) Unbundling could affect the presentation of revenue more than it affects liability recognition. Therefore, unbundling should also be required if it would have a significant effect on reported revenue and is easy to perform. BC50 Some respondents argued that the test for unbundling should be two-sided (ie the cash flows of the insurance component and the investment component do not interact) rather than the one-sided test proposed in ED 5 (ie the cash flows from the insurance component do not affect the cash flows from the deposit component). Here is an example where this might make a difference: in some life insurance contracts, the death benefit is the difference between (a) a fixed amount and (b) the value of a deposit component (for example, a unit-linked investment). The deposit component can be measured independently, but the death benefit depends on the unit value so the insurance component cannot be measured independently. The Board decided that phase I should not require insurers to set up systems to unbundle the products described in the previous paragraph. However, the Board decided to rely on the condition that provides an exemption from unbundling if all the rights and obligations under the deposit component are recognised. If this condition is not met, unbundling is appropriate. Some argued that it is irrelevant whether the insurance component affects the deposit component. They suggested that a deposit component exists if the policyholder will receive a minimum fixed amount of future cash flows in the form of either a return of premium (if no insured event occurs) or an insurance recovery (if an insured event occurs). However, the Board noted that this focus on a single cash flow would not result in unbundling if a financial instrument and an insurance contract are combined artificially into a single contract and the cash flows from one component offset cash flows from the other component. The Board regarded that result as inappropriate and open to abuse. In summary, the Board retained the approach broadly as in ED 5. This requires unbundling if that is needed to ensure the recognition of rights and obligations arising from the deposit component and those rights and obligations can be measured separately. If only the second of these conditions is met, the IFRS permits unbundling, but does not require it.
BC51
BC52
BC53
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BC54
Some respondents suggested that if a contract has been artificially separated through the use of side letters, the separate components of the contract should be considered together. The Board did not address this because it is a wider issue for the Boards possible future work on linkage (ie accounting for separate transactions that are connected in some way). The footnote to paragraph B25 refers to simultaneous contracts with the same counterparty.
Weather derivatives
BC55 The scope of IAS 39 previously excluded contracts that require a payment based on climatic, geological, or other physical variables (if based on climatic variables, sometimes described as weather derivatives). It is convenient to divide these contracts into two categories: (a) contracts that require a payment only if a particular level of the underlying climatic, geological, or other physical variables adversely affects the contract holder. These are insurance contracts as defined in the IFRS. (b) contracts that require a payment based on a specified level of the underlying variable regardless of whether there is an adverse effect on the contract holder. These are derivatives and the IFRS removes a previous scope exclusion to bring them within the scope of IAS 39. BC56 The previous scope exclusion was created mainly because the holder might use such a derivative in a way that resembles the use of an insurance contract. However, the definition of an insurance contract in the IFRS now provides a principled basis for deciding which of these contracts are treated as insurance contracts and which are treated as derivatives. Therefore, the Board removed the scope exclusion from IAS 39 (see paragraph C3 of Appendix C of the IFRS). Such contracts are within the scope of the IFRS if payment is contingent on changes in a physical variable that is specific to a party to the contract, and within the scope of IAS 39 in all other cases. Some respondents suggested that a weather derivative should be treated as: (a) an insurance contract if it is expected to be highly effective in mitigating an existing risk exposure. (b) a derivative financial instrument otherwise. BC58 Some argued that some weather derivatives are, in substance, insurance contracts. For example, under some contracts, the policyholder can claim a fixed sum based on rainfall levels at the nearest weather station.
BC57
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The contract was purchased to provide insurance against low rainfall but was structured like this because of difficulties in measuring actual loss suffered and because of the moral hazard of having a rainfall gauge on the policyholders property. It can reasonably be expected that the rainfall at the nearest weather station will affect the holder, but the physical variable specified in the contract (ie rainfall) is not specific to a party to the contract. Similarly, some insurers use weather derivatives as a hedge against insurance contracts they issue and view them as similar to reinsurance. BC59 Some suggested that weather derivatives should be excluded from the scope of the IFRS because they are tradable instruments that behave like other derivatives and have an observable market value, rather than because there is no contractual link between the holder and the event that triggers payment. The IFRS distinguishes an insurance contract (in which an adverse effect on the policyholder is a contractual precondition for payment) from other instruments, such as derivatives and weather derivatives (in which an adverse effect is not a contractual precondition for payment, although the counterparty may, in fact, use the instrument to hedge an existing exposure). In the Boards view, this is an important and useful distinction. It is much easier to base a classification on the terms of the contract than on an assessment of the counterpartys motive (ie hedging or trading). Consequently, the Board made no change to ED 5s proposals for the treatment of weather derivatives.
BC60
Scope exclusions
BC61 The scope of the IFRS excludes various items that may meet the definition of insurance contracts, but are, or will be, covered by existing or proposed future IFRSs (paragraph 4). The following paragraphs discuss: (a) financial guarantees and insurance against credit risk (paragraphs BC62-BC68); (b) product warranties (paragraphs BC69-BC72); (c) accounting by policyholders (paragraph BC73); and (d) prepaid service contracts (paragraphs BC74-BC76).
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Financial guarantees and insurance against credit risk

BC62 Some contracts require specified payments to reimburse the holder for a loss it incurs if a specified debtor fails to make payment when due under the original or modified terms of a debt instrument. If the resulting risk transfer is significant, these contracts meet the definition of an insurance contract. Some of these contracts have the legal form of an insurance contract and others have the legal form of a financial guarantee or letter of credit. In the Boards view, although this difference in legal form may be associated in some cases with differences in substance, the same accounting requirements should, in principle, apply to all contracts with similar substance. Some took the view that the scope of IAS 39 should include all contracts that provide cover against credit risk, on the following grounds: (a) Although credit insurers manage credit risk by pooling individual risk within a portfolio, banks also do this in managing the credit risk in a portfolio of financial guarantees. Although banks may rely more on collateral, this is no reason to require a different accounting treatment. (b) Banks manage credit risk embedded in their financial assets, and there is no reason to require them to apply a different standard to credit risk embedded in financial guarantees. (c) Credit risk is commonly traded in capital markets, even if the specific forms of credit risk embedded in some forms of credit insurance are not traded. (d) As noted above, some financial guarantees were already within the scope of IAS 39. To ensure consistent reporting, the scope of IAS 39 should include all contracts that provide protection against similar exposures. BC64 Some argued that insurance against credit risk is different from a financial guarantee and should be within the scope of IFRS 4, on the following grounds: (a) Insurance against credit risk is often arranged by the seller of goods and protects the seller against default by the buyer. The fact that default is generally outside the control of the seller, and so is fortuitous, allows the use of stochastic methods to estimate future cash flows arising from the contract, because they are random and not subject to moral hazard. By contrast, some financial
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guarantees, such as some letters of credit, are arranged at the request of the party whose obligation is being guaranteed. Default on such guarantees is partly under the control of that party. (b) Insurance against credit risk is part of an insurers overall insurance activity, and is managed as part of a diversified portfolio in the same way as other insurance activities. (c) A credit insurer may refuse to pay a claim if the policyholder did not give full disclosure and may delay payment while a claim is investigated, whereas a guarantor is often required to pay on first notice of a default. (d) A credit insurer faces risks similar to those arising in some other insurance contracts. For example, a contract may require payments (either to the debtor or to the creditor) if a debtors income is reduced by specified adverse events such as unemployment or illness, regardless of whether the debtor continues to make loan payments when due. The issuer of this contract may face risks similar to those faced by a guarantor of the loan. (e) Including these contracts within the scope of IAS 39 would compel credit insurers to change their accounting immediately, unlike issuers of other types of insurance contract. Furthermore, some credit insurance contracts contain features, such as cancellation and renewal rights and profit-sharing features, that the Board will not resolve until phase II. BC65 When the Board developed ED 5, the following contracts were already within the scope of IAS 39 and the Board concluded that they should remain so: (a) a financial guarantee given or retained by a transferor when it derecognises financial assets or financial liabilities. In general, IAS 39 prevents the derecognition of the transferred asset or liability when such a guarantee exists. (b) a financial guarantee that does not meet the definition of an insurance contract. BC66 Other financial guarantees were within the scope of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. In June 2002, an Exposure Draft of amendments to IAS 39 proposed that IAS 39 should deal with all financial guarantees at initial recognition, but that the subsequent measurement of some financial guarantees should remain within the scope of IAS 37. In finalising the revision of IAS 39, issued in December 2003, the Board decided that the issuer of the financial guarantees described in paragraph BC62 (ie those that meet the definition of an
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insurance contract) should initially recognise them at fair value, and subsequently measure them at the higher of (a) the amount recognised under IAS 37 and (b) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18 Revenue. BC67 In finalising IFRS 4, the Board reached the following conclusions: (a) Financial guarantees can have various legal forms, such as that of a financial guarantee, letter of credit, credit default contract or insurance contract. The accounting should not depend on their legal form. (b) A financial guarantee contract should be within the scope of IAS 39 if it is not an insurance contract, as defined in IFRS 4. A financial guarantee qualifies as an insurance contract if it requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due under the original or modified terms of a debt instrument, provided that the resulting risk transfer is significant. (c) If an insurance contract is a financial guarantee contract incurred or retained on transferring to another party financial assets or financial liabilities within the scope of IAS 39, the issuer should apply IAS 39 to that contract (even though the contract is an insurance contract, as defined). (d) Unless (c) applies, the measurement described in the last sentence of paragraph BC66 is appropriate for a financial guarantee contract that meets the definition of an insurance contract. However, the Board acknowledged the need to expose this conclusion for comment. Mindful of the need to develop a stable platform of Standards for 2005, the Board decided to finalise IFRS 4 without specifying the accounting for these contracts and to develop an Exposure Draft on this topic. In the meantime, the liability adequacy test in paragraphs 15-19 may be particularly relevant if the insurers accounting policies would not otherwise require it to recognise a liability at the inception of the contract. (e) ED 5 proposed that guarantees incurred or retained on derecognition of a non-financial asset or non-financial liability should be treated in the same way as guarantees incurred or retained on derecognition of a financial asset or financial liability. However, no respondents commented on the substance of this proposal and entities responding to ED 5 were not the entities most likely to be
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affected by this proposal. Therefore, the Board decided to delete the proposal in finalising IFRS 4. It follows that financial guarantees incurred or retained on the transfer of a non-financial asset: (i) are within the scope of IFRS 4 if they meet the definition of an insurance contract (pending amendments from the Exposure Draft discussed in (d)). Among other things, this means that the guarantee given is subject to the liability adequacy test described in paragraphs 15-19 of the IFRS. are not recognised separately if they prevent the derecognition of a non-financial asset, for example if they mean that the transfer does not meet the revenue recognition criteria in IAS 18. In such case, the proceeds received are typically recognised as a liability. otherwise, are within the scope of IAS 39.
(ii)
(iii) BC68
Some respondents asked the Board to give specific guidance on accounting for financial guarantees received. However, the Board decided that this would not be appropriate. For contracts classified as insurance contracts, the beneficiary of the guarantee is a policyholder; policyholder accounting is beyond the scope of IFRS 4. For contracts within the scope of IAS 39, the beneficiary applies IAS 39; the application of IAS 39 to other contracts is beyond the scope of this project.
Product warranties
BC69 A product warranty clearly meets the definition of an insurance contract if an entity issues it on behalf of another party (such as a manufacturer, dealer or retailer). The scope of the IFRS includes such warranties. A product warranty issued directly by a manufacturer, dealer or retailer also meets the definition of an insurance contract. Although some might think of this as self-insurance, the risk retained arises from existing contractual obligations towards the customer. Some may reason that the definition of insurance contracts should exclude such direct warranties because they do not involve a transfer of risk from buyer to seller, but rather a crystallisation of an existing responsibility. However, in the Boards view, excluding these warranties from the definition of insurance contracts would complicate the definition for only marginal benefit. Although such direct warranties create economic exposures similar to warranties issued on behalf of the manufacturer, dealer or retailer by another party (ie the insurer), the scope of the IFRS excludes them
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because they are closely related to the underlying sale of goods and because IAS 37 addresses product warranties. IAS 18 deals with the revenue received for such warranties. BC72 In a separate project, the Board is exploring an asset and liability approach to revenue recognition. If this approach is implemented, the accounting model for these direct product warranties may change.
Accounting by policyholders
BC73 The IFRS does not address accounting and disclosure by policyholders for direct insurance contracts because the Board does not regard this as a high priority for phase I. The Board intends to address accounting by policyholders in phase II (see IASB Update February 2002 for the Boards discussion of accounting by policyholders). IFRSs address some aspects of accounting by policyholders for insurance contracts: (a) IAS 37 addresses accounting for reimbursements from insurers for expenditure required to settle a provision. (b) IAS 16 addresses some aspects of compensation from third parties for property, plant and equipment that was impaired, lost or given up. (c) Because policyholder accounting is outside the scope of the IFRS, the hierarchy of criteria in paragraphs 10-12 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors applies to policyholder accounting (see paragraphs BC77-BC86). (d) A policyholders rights and obligations under insurance contracts are outside the scope of IAS 32 and IAS 39.
Prepaid service contracts

BC74 Some respondents noted that the definition proposed in ED 5 captured some prepaid contracts to provide services whose cost is uncertain. Because these contracts are not normally regarded as insurance contracts, these respondents suggested that the Board should change the definition or exclude these contracts from the scope of the IFRS. Respondents cited two specific examples. (a) Fixed fee service contracts if the level of service depends on an uncertain event, for example maintenance contracts if the service provider agrees to repair specified equipment after a malfunction. The fixed service fee is based on the expected number of malfunctions, although it is uncertain that the machines will actually
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break down. The malfunction of the equipment adversely affects its owner and the contract compensates the owner (in kind, rather than cash). (b) Some car breakdown assistance if (i) each breakdown has little incremental cost because employed patrols provide most of the assistance, (ii) the motorist pays for all parts and repairs, (iii) the service providers only responsibility is to take the car to a specified destination (eg the nearest garage, home or the original destination), (iv) the need to provide assistance (and the related cost) is known within hours and (v) the number of call-outs is limited. BC75 The Board saw no conceptual reason to change either the definition of insurance contracts or the scope of the IFRS in the light of the two examples cited by respondents. Paragraphs B6 and B7 of the IFRS note that complying with the IFRS in phase I is unlikely to be particularly burdensome in these two examples, for materiality reasons. The Board may need to review this conclusion in phase II. Some respondents argued that the proposals in ED 5 were directed primarily at entities that are generally regarded as insurers. They suggested that the Board should not impose these proposals on entities that have a relatively small amount of a given transaction type. The Board concluded that these comments were primarily about materiality. IAS 1 Presentation of Financial Statements and IAS 8 address materiality and the Board decided that no further guidance or specific exemption was needed in this case.
BC76
TEMPORARY EXEMPTION FROM SOME OTHER IFRSs

BC77 Paragraphs 10-12 of IAS 8 specify a hierarchy of criteria that an entity should use in developing an accounting policy if no IFRS applies specifically to an item. Without changes made in the IFRS, an insurer adopting IFRSs in 2005 would have needed to assess whether its accounting policies for insurance contracts comply with these requirements. In the absence of guidance, there might have been uncertainty about what would be acceptable. Establishing what would be acceptable could have been costly and some insurers might have made major changes in 2005 followed by further significant changes in phase II. To avoid unnecessary disruption for both users and preparers in phase I that would not have eased the transition to phase II, the Board decided to limit the need for insurers to change their existing accounting policies for insurance contracts. The Board did this by the following measures:
BC78
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(a) creating a temporary exemption from the hierarchy in IAS 8 that specifies the criteria an entity uses in developing an accounting policy if no IFRS applies specifically to an item. The exemption applies to insurers, but not to policyholders. (b) limiting the impact of that exemption from the hierarchy by five specific requirements (relating to catastrophe provisions, liability adequacy, derecognition, offsetting and impairment of reinsurance assets, see paragraphs BC87-BC114). (c) permitting some existing practices to continue but prohibiting their introduction (paragraphs BC123-BC146). BC79 Some respondents opposed the exemption from the hierarchy on the grounds that it would permit too much diversity and allow fundamental departures from the Framework that could prevent an insurers financial statements from presenting information that is understandable, relevant, reliable and comparable. The Board did not grant the exemption from the hierarchy in IAS 8 lightly, but took this unusual step to minimise disruption in 2005 for both users (eg lack of continuity of trend data) and preparers (eg systems changes). ED 6 Exploration for and Evaluation of Mineral Resources proposes a temporary exemption from paragraphs 11 and 12 of IAS 8 (ie sources of guidance), but not from paragraph 10 (ie relevance and reliability). That proposed exemption is narrower than in IFRS 4 because ED 6 leaves a relatively narrow range of issues unaddressed. In contrast, because IFRS 4 leaves many significant aspects of accounting for insurance contracts until phase II, a requirement to apply paragraph 10 of IAS 8 to insurance contracts would have had much more pervasive effects and insurers would have needed to address matters such as completeness, substance over form and neutrality. Some suggested that the Board should specifically require an insurer to follow its national accounting requirements (national GAAP) in accounting for insurance contracts during phase I, to prevent selection of accounting policies that do not form a comprehensive basis of accounting to achieve a predetermined result (cherry-picking). However, defining national GAAP would have posed problems. Further definitional problems could have arisen because some insurers do not apply the national GAAP of their own country. For example, some non-US insurers with a US listing apply US GAAP. Moreover, it is unusual and, arguably, beyond the Boards mandate to impose requirements set by another body. In addition, an insurer might wish to improve its accounting policies to reflect other accounting developments with no counterpart in national GAAP. For example, an insurer adopting IFRSs for the first time might
BC80
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BC82
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wish to amend its accounting policies for insurance contracts for greater consistency with accounting policies that it uses for contracts within the scope of IAS 39. Similarly, an insurer might wish to improve its accounting for embedded options and guarantees by addressing both their time value and their intrinsic value, even if no similar improvements are made to its national GAAP. BC83 Therefore, the Board decided that an insurer could continue to follow the accounting policies that it was using when it first applied the phase I requirements, with some exceptions noted below. An insurer could also improve those accounting policies if specified criteria are met (see paragraphs 21-30 of the IFRS). The criteria in paragraphs 10-12 of IAS 8 include relevance and reliability. Granting an exemption from those criteria, even temporarily, is a highly unusual step. The Board was prepared to contemplate that step only as part of an orderly and relatively fast transition to phase II. Because the exemption is so exceptional, ED 5 proposed that it would apply only for accounting periods beginning before 1 January 2007. Some described this time limit as a sunset clause. Many respondents opposed the sunset clause. following: They argued the
BC84
BC85
(a) If the exemption expired in 2007 before phase II is in force, there would be considerable confusion, disruption and cost for both users and preparers. It would not be appropriate to penalise users and preparers if the Board does not complete phase II on time. (b) The sunset clause might be perceived as putting pressure on the Board to complete phase II without adequate consultation, investigation and testing. The Board accepted the validity of these objections to the sunset clause and deleted it. BC86 The Board decided to maintain some requirements that follow from the criteria in IAS 8. The Board acknowledges that it is difficult to make piecemeal changes to recognition and measurement practices in phase I because many aspects of accounting for insurance contracts are interrelated with aspects that will not be completed until phase II. However, abandoning these particular requirements would detract from the relevance and reliability of an insurers financial statements to an unacceptable degree. Moreover, these requirements are not interrelated to a great extent with other aspects of recognition and measurement and the Board does not expect phase II to reverse these requirements. The following points are discussed below:
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(a) catastrophe and equalisation provisions (paragraphs BC87-BC93) (b) liability adequacy (paragraphs BC94-BC104) (c) derecognition (paragraph BC105) (d) offsetting (paragraph BC106) (e) impairment of reinsurance assets (paragraphs BC107-BC114).
Catastrophe and equalisation provisions

BC87 Some insurance contracts expose the insurer to infrequent but severe catastrophic losses caused by events such as damage to nuclear installations or satellites or earthquake damage. Some jurisdictions permit or require catastrophe provisions for contracts of this type. The catastrophe provisions are generally built up gradually over the years out of the premiums received, usually following a prescribed formula, until a specified limit is reached. They are intended to be used on the occurrence of a future catastrophic loss that is covered by current or future contracts of this type. Some countries also permit or require equalisation provisions to cover random fluctuations of claim expenses around the expected value of claims for some types of insurance contract (eg hail, credit, guarantee and fidelity insurance) using a formula based on experience over a number of years. Those who favour recognising catastrophe or equalisation provisions as liabilities base their view on one or more of the following arguments: (a) Such provisions represent a deferral of unearned premiums that are designed to provide for events that are not expected, on average, to occur in any single contract period but are expected to occur over an entire cycle of several contract periods. Although contracts cover only one period in form, in substance contracts are commonly renewed, leading to pooling of risks over time rather than within a single period. Indeed, some jurisdictions make it difficult for an insurer to stop offering insurance against some forms of risk, such as hurricanes. (b) In some jurisdictions, an insurer is required to segregate part of the premium (the catastrophe premium). The catastrophe premium is not available for distribution to shareholders (except on liquidation) and, if the insurer transfers the contract to another insurer, it must also transfer the catastrophe premium.
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(c) In years when no catastrophe occurs (or when claims are abnormally low), such provisions portray an insurers long-term profitability faithfully because they match the insurers costs and revenue over the long term. Also, they show a pattern of profit similar to one obtained through reinsurance, but with less cost and administrative burden. (d) Such provisions enhance solvency protection by restricting the amounts distributed to shareholders and by restricting a weak companys ability to expand or enter new markets. (e) Such provisions encourage insurers to accept risks that they might otherwise decline. Some countries reinforce this encouragement with tax deductions. BC89 For the following reasons, the IFRS prohibits the recognition as a liability of provisions for possible future claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions): (a) 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 current contract period. As the Framework states, the matching concept does not allow the recognition of items in the balance sheet that do not meet the definition of assets or liabilities. Recognising deferred credits as if they were liabilities would diminish the relevance and reliability of an insurers financial statements. (b) Even if the insurance law requires an insurer to segregate catastrophe premiums so that they are not available for distribution to shareholders in any circumstances, earnings on those segregated premiums will ultimately be available to shareholders. Therefore, those segregated amounts are appropriately classified as equity, not as a liability. (c) Recognising such provisions obscures users ability to examine the impact of past catastrophes and does not contribute to their analysis of an insurers exposure to future catastrophes. Given adequate disclosure, knowledgeable users understand that some types of insurance expose an insurer to infrequent but severe losses. Moreover, the analogy with reinsurance contracts is irrelevant, because reinsurance actually changes the insurers risk profile. (d) The objective of general purpose financial statements is not to enhance solvency but to provide information that is useful to a wide range of users for economic decisions. Moreover, the recognition of
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provisions does not, by itself, enhance solvency. However, if the objective of financial statements were to enhance solvency and such provisions were an appropriate means of enhancing solvency, it would follow that the insurer should recognise the entire provision immediately, rather than accumulating it over time. Furthermore, if catastrophes (or unusual experience) in one period are independent of those in other periods, the insurer should not reduce the liability when a catastrophe (or unusually bad experience) occurs. Also, if diversification over time were a valid basis for accounting, above-average losses in early years should be recognised as assets, yet proponents of catastrophe and equalisation provisions do not advocate this. (e) Recognising catastrophe or equalisation provisions is not the only way to limit distributions to shareholders. Other measures, such as solvency margin requirements and risk-based capital requirements, could play an important role. Another possibility is for an insurer to segregate a portion of its equity for retention to meet possible losses in future years. (f) The objective of general purpose financial statements is not to encourage or discourage particular transactions or activities, but to report neutral information about transactions and activities. Therefore, accounting requirements should not try to encourage insurers to accept or decline particular types of risks.
(g) If an insurer expects to continue writing catastrophe cover, presumably it believes that the future business will be profitable. It would not be representationally faithful to recognise a liability for future contracts that are expected to be profitable. (h) There is no objective way to measure catastrophe and equalisation provisions, unless an arbitrary formula is used. BC90 Some suggested that it is not appropriate to eliminate catastrophe and equalisation provisions in phase I as a piecemeal amendment to existing approaches. However, the Board concluded that it could prohibit these provisions without undermining other components of existing approaches. There is no credible basis for arguing that catastrophe or equalisation provisions are recognisable liabilities under IFRSs and there is no realistic prospect that the Board will permit them in phase II. Indeed, as noted above, paragraphs 10-12 of IAS 8 require an entity to consider various criteria in developing an accounting policy for an item if no IFRS applies specifically to that item. In the Boards view, if the IFRS had not
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suspended that requirement, it would clearly have prohibited the recognition of such items as a liability. Accordingly, the IFRS preserves this prohibition (see paragraph 14(a) of the IFRS). BC91 Some respondents presented additional arguments for permitting the recognition of catastrophe and equalisation provisions as a liability: (a) Some insurers measure insurance contracts without margins for risk, but instead recognise catastrophe or equalisation provisions. If catastrophe provisions are eliminated in phase I, this change might be partly reversed in phase II if insurers are then required to include margins for risk. (b) Some insurers regard these provisions as relating partly to existing contracts and partly to future contracts. Splitting these components may be difficult and involve systems changes that might not be needed in phase II. BC92 For the following reasons, these arguments did not persuade the Board: (a) Present imperfections in the measurement of recognisable liabilities do not justify the recognition of other items that do not meet the definition of a liability. (b) Additions to these provisions are often based on a percentage of premium revenue. If the risk period has already expired, that premium does not relate to an existing contractual obligation. If the risk period has not yet fully expired, the related portion of the premium relates to an existing contractual obligation, but most existing models defer all the related premium as unearned premium, so recognising an additional provision would be double-counting (unless the contract were known to be underpriced). BC93 Accordingly, the Board retained the proposal in ED 5 to eliminate these provisions. However, although the IFRS prohibits their recognition as a liability, it does not prohibit the segregation of a component of equity. Changes in a component of equity are not recognised in profit or loss. IAS 1 requires a statement of changes in equity.
Liability adequacy
BC94 Many existing accounting models have tests to confirm that insurance liabilities are not understated, and that related amounts recognised as assets, such as deferred acquisition costs, are not overstated. The precise form of the test depends on the underlying measurement approach. However, there is no guarantee that these tests exist
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everywhere and the credibility of IFRSs could suffer if an insurer claims to comply with IFRSs but fails to recognise material and reasonably foreseeable losses arising from existing contractual obligations. To avoid this, the IFRS requires a liability adequacy test* (see paragraphs 15-19). BC95 The Boards intention was not to introduce piecemeal elements of a parallel measurement model, but to create a mechanism that reduces the possibility that material losses remain unrecognised during phase I. With this in mind, paragraph 16 of the IFRS defines minimum requirements that an insurers existing test must meet. If the insurer does not apply a test that meets those requirements, it must apply a test specified by the Board. To specify a test on a basis that already exists in IFRSs and minimise the need for exceptions to existing principles, the Board decided to draw on IAS 37. The liability adequacy test also applies to deferred acquisition costs and to intangible assets representing the contractual rights acquired in a business combination or portfolio transfer. As a result, when the Board revised IAS 36 Impairment of Assets in 2004, it excluded deferred acquisition costs and those intangible assets from the scope of IAS 36. The Board considered whether it should retain the impairment model in IAS 36 for deferred acquisition costs, and perhaps also the related insurance liabilities. However, the IAS 36 model cannot be applied to deferred acquisition costs alone, without also considering the cash flows relating to the recognised liability. Indeed, some insurers capitalise acquisition costs implicitly through deductions in the measurement of the liability. Moreover, it would be confusing and difficult to apply this model to liabilities without some re-engineering. In the Boards view, it is simpler to use a model that is designed for liabilities, namely the IAS 37 model. In practice, a re-engineered IAS 36 model and IAS 37 might not lead to very different results. Some respondents suggested that the Board should specify that the cash flows considered in a liability adequacy test should include the effect of embedded options and guarantees, such as guaranteed annuity rates. They expressed concerns that many national practices have not required insurers to recognise these exposures, which can be very large. Although the Boards objective was not to develop a detailed liability adequacy test, it observed that the size of exposures to embedded guarantees and options and the failings of many national practices in this area warranted specific requirements, even in phase I. Accordingly, the Board decided that the minimum requirements for an existing liability
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ED 5 described this as a loss recognition test.
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adequacy test should include considering cash flows resulting from embedded options and guarantees. The Board did not specify how those cash flows should be considered but noted that an insurer would consider this matter in developing disclosures of its accounting policies. If an existing liability adequacy test does not meet the minimum requirements, a comparison is made with the measurement that IAS 37 would require. IAS 37 refers to the amount that an entity would rationally pay to settle the obligation or transfer it to a third party. Implicitly, this amount would consider the possible effect of embedded options and guarantees. BC100 ED 5 did not specify the level of aggregation for the liability adequacy test and some respondents asked the Board to clarify this. Paragraph 18 of the IFRS confirms that the aggregation requirements of the existing liability adequacy test apply if the test meets the minimum requirements specified in paragraph 16 of the IFRS. If that test does not meet those minimum requirements, there is no conceptual justification for offsetting a loss on one contract against an otherwise unrecognisable gain on another contract. However, the Board concluded that a contract-by-contract assessment would impose costs that exceed the likely benefits to users. Therefore, paragraph 18 states that the comparison is made at the level of a portfolio of contracts that are subject to broadly similar risks and managed together as a portfolio. More precise definition would be difficult and is not needed, given the Boards restricted objective of ensuring at least a minimum level of testing for the limited life of phase I. BC101 It is beyond the scope of phase I to create a detailed accounting regime for insurance contracts. Therefore, the IFRS does not specify: (a) what criteria determine when existing contracts end and future contracts start. (b) whether or how the cash flows are discounted to reflect the time value of money or adjusted for risk and uncertainty. (c) whether the liability adequacy test considers both the time value and the intrinsic value of embedded options and guarantees. (d) whether additional losses recognised because of the liability adequacy test are recognised by reducing the carrying amount of deferred acquisition costs or by increasing the carrying amount of the related insurance liabilities. BC102 Some respondents asked the Board to clarify that no formal liability adequacy test is needed if an entity can demonstrate that its method of measuring insurance liabilities means that they are not understated. Paragraph 15 of the IFRS requires an insurer to assess whether its recognised insurance liabilities are adequate, using current estimates of
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future cash flows. The fundamental point is that future cash flows must be considered in some way, and not merely be assumed to support the existing carrying amount. The IFRS does not specify the precise means of ensuring this, as long as the minimum requirements in paragraph 16 are met. BC103 Some respondents read the liability adequacy test proposed in ED 5 as requiring fair value measurement as a minimum. That was not the Boards intention. An insurer needs to refer to IAS 37 only if the minimum requirements in paragraph 16 are not met. BC104 Some respondents noted that many existing liability adequacy tests require measurements that do not include a risk margin. However, IAS 37 requires such a margin. To achieve consistency, these respondents suggested that a liability adequacy test under IAS 37 should also exclude these margins. The Board did not adopt this suggestion. The idea behind using IAS 37 for phase I was to take an existing measurement basis off the shelf rather than create a new model.
Derecognition
BC105 The Board identified no reasons why derecognition requirements for insurance liabilities and insurance assets should differ from those for financial liabilities and financial assets. Therefore, the derecognition requirements for insurance liabilities are the same as for financial liabilities (see paragraph 14(c) of the IFRS). However, because derecognition of financial assets is a controversial topic, the IFRS does not address derecognition of insurance assets.
Offsetting
BC106 A cedant (ie the insurer that is the policyholder under a reinsurance contract) does not normally have a right to offset amounts due from a reinsurer against amounts due to the underlying policyholder. Normal offsetting criteria prohibit offsetting when no such right exists. When these criteria are not met, a gross presentation gives a clearer picture of the cedants rights and obligations, and related income and expense (see paragraph 14(d) of the IFRS).
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Reinsurance assets
Impairment of reinsurance assets
BC107 ED 5 proposed that a cedant should apply IAS 36 Impairment of Assets to its reinsurance assets. Respondents opposed this proposal for the following reasons: (a) This would compel many cedants to change their accounting model for reinsurance contracts in a way that is inconsistent with the accounting for the underlying direct insurance liability. (b) IAS 36 would require the cedant to address matters that are beyond the scope of phase I for the underlying direct insurance liability, such as the cash flows to be discounted, the discount rate and the approach to risk. Some saw IAS 36 as an indirect way of imposing something similar to a fair value model. There would also have been systems implications. (c) Reinsurance assets are essentially a form of financial asset and should be subject, for impairment testing, to IAS 39 rather than IAS 36. BC108 The Board concluded that an impairment test for phase I (a) should focus on credit risk (arising from the risk of default by the reinsurer and also from disputes over coverage) and (b) should not address matters arising from the measurement of the underlying direct insurance liability. The Board decided that the most appropriate way to achieve this was an incurred loss model based on that in IAS 39 (see paragraph 20 of the IFRS).
Gains and losses on buying reinsurance

BC109 The IFRS defines a reinsurance contract as an insurance contract issued by one insurer (the reinsurer) to compensate another insurer (the cedant) for losses on one or more contracts issued by the cedant. One consequence is that the level of insurance risk required to meet the definition of an insurance contract is the same for a reinsurance contract as for a direct insurance contract. BC110 National accounting requirements often define reinsurance contracts more strictly than direct insurance contracts to avoid distortion through contracts that have the legal form of reinsurance but do not transfer significant insurance risk (sometimes known as financial reinsurance). One source of such distortions is the failure to discount many non-life insurance claims liabilities. If the insurer buys reinsurance, the premium
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paid to the reinsurer reflects the present value of the liability and is, therefore, less than the previous carrying amount of the liability. Reporting a gain on buying the reinsurance is not representationally faithful if no economic gain occurred at that time. The accounting gain arises largely because of the failure to use discounting for the underlying liability. Similar problems arise if the underlying insurance liability is measured with excessive prudence. BC111 The Board decided that it would not use the definition of a reinsurance contract to address these problems because the Board found no conceptual reason to define a reinsurance contract more or less strictly than a direct insurance contract. Instead, ED 5 addressed these problems through the following proposals: (a) prohibiting derecognition if the liability is not extinguished (paragraphs 14(c) of the IFRS and BC105) and prohibiting the offsetting of reinsurance assets against the related direct insurance liabilities (paragraphs 14(d) of the IFRS and BC106). (b) requiring unbundling in some cases (paragraphs 10-12 of the IFRS, IG Example 3 in the Implementation Guidance and paragraphs BC40-BC54). (c) limiting the recognition of gains when an insurer buys reinsurance. BC112 Respondents to ED 5 generally opposed the proposal described in paragraph BC111(c), on the following grounds: (a) These piecemeal amendments to existing accounting models were beyond the scope of phase I and would require new systems that might not be needed in phase II. (b) The proposals would have been difficult to apply to more complex reinsurance contracts, including excess of loss contracts and contracts that reinsure different layers of a portfolio of underlying direct insurance contracts. (c) The proposals would have created inconsistencies with the measurement of the underlying direct insurance contracts. (d) The artificial gain recognised at inception of some reinsurance contracts mitigates an artificial loss that arose earlier from excessive prudence or lack of discounting. If the net exposure has been reduced by reinsurance, there is no reason to continue to overstate the original liability. (e) Any deferral of profit on buying reinsurance should be recognised as a liability, not as a reduction in the carrying amount of the reinsurance asset. This would permit assets and liabilities relating
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to the same underlying insurance contracts to be measured on a consistent basis and would also be consistent with other accounting bases such as US GAAP. (f) Any restrictions in phase I should be targeted more precisely at financial reinsurance transactions (ie transactions that do not meet the definition of an insurance contract or that have significant financial components) or contracts that provide retroactive cover (ie ones that cover events that have already occurred).
(g) The liability adequacy test and unbundling proposals would have provided sufficient safeguards against the recognition of excessive profits. BC113 The Board considered limiting the proposed requirements to cases where significant distortions in reported profit were most likely to occur, for example retroactive contracts. However, developing such a distinction would have been time-consuming and difficult, and there would have been no guarantee of success. The Board also considered drawing on requirements in US GAAP but decided not to include detailed requirements of this kind as a temporary and only partly effective solution. The proposals in ED 5 were an attempt to develop a simpler temporary solution. The responses indicated that the proposed solution contained too many imperfections to achieve its purpose. BC114 The Board decided to delete the proposal in ED 5 and replace it with a specific disclosure requirement for gains and losses that arose on buying reinsurance (see paragraph 37(b) of the IFRS).
Other existing practices

BC115 The IFRS does not address: (a) acquisition costs (paragraphs BC116-BC119); (b) salvage and subrogation (paragraphs BC120 and BC121); and (c) policy loans (paragraph BC122).
Acquisition costs
BC116 Acquisition costs are the costs that an insurer incurs to sell, underwrite and initiate a new insurance contract. The IFRS neither prohibits nor requires the deferral of acquisition costs, nor does it prescribe what acquisition costs are deferrable, the period and method of their amortisation or whether an insurer should present deferred acquisition
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costs as an asset or as a reduction in insurance liabilities. The treatment of deferred acquisition costs is an integral part of existing models and cannot be amended easily without a more fundamental review of those models in phase II. BC117 The treatment of acquisition costs for insurance contracts in phase I may differ from the treatment of transaction costs incurred for investment contracts (ie financial liabilities). IAS 39 requires specified transaction costs to be presented as a deduction in determining the initial carrying amount of a financial liability. The Board did not wish to create exceptions to the definition of the transaction costs to which this treatment applies. Those costs may be defined more broadly or more narrowly than the acquisition costs that an insurer is required or permitted to defer using its existing accounting policies. BC118 Some entities incur significant costs in originating long-term savings contracts. Some respondents argued that most, if not all, of these costs relate to the right to charge future investment management fees rather than to the financial liability that is created when the first instalment is received. They asked the Board to clarify whether the cost of originating those rights could be recognised as a separate asset rather than as a deduction in determining the initial carrying amount of the financial liability. They noted that this treatment would: (a) simplify the application of the effective interest method for a financial liability carried at amortised cost. (b) prevent the recognition of a misleading loss at inception for a financial liability that contains a demand feature and is carried at fair value. IAS 39 states that the fair value of such a liability is not less than the amount payable on demand (discounted, if applicable, from the first date when that amount could be required to be paid). BC119 In response to these comments, the Board decided that incremental costs directly attributable to securing an investment management contract should be recognised as an asset if they meet specified criteria, and that incremental costs should be defined in the same way as in IAS 39. The Board clarified these points by adding guidance to the appendix of IAS 18 Revenue.
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Salvage and subrogation

BC120 Some insurance contracts permit the insurer to sell (usually damaged) property acquired in settling the claim (ie salvage). The insurer may also have the right to pursue third parties for payment of some or all costs (ie subrogation). The Board will consider salvage and subrogation in phase II. BC121 In the following two related areas, the IFRS does not amend IAS 37: (a) Gains on the expected disposal of assets are not taken into account in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision. Instead, an entity recognises gains on expected disposals of assets at the time specified by the IFRS dealing with the assets concerned (paragraphs 51 and 52 of IAS 37). (b) Paragraphs 53-58 of IAS 37 address reimbursements for some or all of the expenditure required to settle a provision. The Board is working on a project to amend various aspects of IAS 37.
Policy loans
BC122 Some insurance contracts permit the policyholder to obtain a loan from the insurer. The DSOP proposed that an insurer should treat these loans as a prepayment of the insurance liability, rather than as the creation of a separate financial asset. Because the Board does not regard this issue as a priority, phase I does not address it.
CHANGES IN ACCOUNTING POLICIES Relevance and reliability

BC123 IAS 8 prohibits a change in accounting policies that is not required by an IFRS, unless the change will result in the provision of reliable and more relevant information. Although the Board wished to avoid imposing unnecessary changes in phase I, it saw no need to exempt insurers from the requirement to justify changes in accounting policies. Therefore, paragraph 22 of the IFRS permits an insurer to change its accounting policies for insurance contracts if, and only if, the change makes the financial statements more relevant and no less reliable or more reliable
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and no less relevant, judged by the criteria in IAS 8.* As the Boards conclusions for phase II develop (see paragraphs BC6-BC8), they will give insurers further context for judgements about whether a change in accounting policies will make their financial statements more relevant and reliable. BC124 The IFRS contains further specific requirements supporting paragraph 22: (a) paragraph 24 permits an insurer to change its accounting policies for some insurance liabilities that it designates, without satisfying the normal requirement in IAS 8 that an accounting policy should be applied to all similar items (paragraphs BC174-BC177). (b) paragraph 25 permits the following practices to continue but prohibits their introduction: (i) (ii) measuring insurance liabilities on an undiscounted basis (paragraphs BC126 and BC127). measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current fees charged by other market participants for similar services (paragraphs BC128BC130). using non-uniform accounting policies for the insurance contracts of subsidiaries (paragraphs BC131 and BC132).
(iii)
(c) paragraph 26 prohibits the introduction of additional prudence if an insurer already measures insurance liabilities with sufficient prudence (paragraph BC133). (d) paragraphs 27-29 create a rebuttable presumption against the introduction of future investment margins in the measurement of insurance contracts (paragraphs BC134-BC144). (e) paragraph 30 addresses BC181-BC184). (f) shadow accounting (paragraphs
paragraph 45 permits an insurer to redesignate financial assets as at fair value through profit or loss when it changes its accounting policies for insurance liabilities (paragraphs BC145 and BC146).
Unlike IAS 8, paragraph 22 of the IFRS permits changes in accounting policies that make the financial statements more reliable and no less relevant. This permits improvements that make financial statements more reliable even if they do not achieve full reliability. In IAS 8 and the Framework, reliability is not synonymous with verifiability but includes characteristics such as neutrality and substance over form.
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BC125 Some respondents suggested that phase I should not permit changes in accounting policies, to prevent lack of comparability (especially within a country) and management discretion to make arbitrary changes. However, the Board decided to permit changes in accounting policies for insurance contracts if they make the financial statements more relevant and no less reliable, or more reliable and no less relevant.
Discounting
BC126 In present practice, most general insurance claims liabilities are not discounted. In the Boards view, discounting of insurance liabilities results in financial statements that are more relevant and reliable. However, because the Board will not address discount rates and the basis for risk adjustments until phase II, the Board concluded that it could not require discounting in phase I. Nevertheless, the IFRS prohibits a change from an accounting policy that involves discounting to one that does not involve discounting (paragraph 25(a)). BC127 Some respondents to ED 5 opposed discounting for contracts in which almost all the cash flows are expected to arise within one year, on materiality and cost-benefit grounds. The Board decided to create no specific exemption for these liabilities, because the normal materiality criteria in IAS 8 apply.
Investment management fees

BC128 Under some insurance contracts, the insurer is entitled to receive a periodic investment management fee. Some suggest that the insurer should, in determining the fair value of its contractual rights and obligations, discount the estimated future cash flows at a discount rate that reflects the risks associated with the cash flows. Some insurers use this approach in determining embedded values. BC129 However, in the Boards view, this approach can lead to results that are not consistent with a fair value measurement. If the insurers contractual asset management fee is in line with the fee charged by other insurers and asset managers for comparable asset management services, the fair value of the insurers contractual right to that fee would be approximately equal to what it would cost insurers and asset managers to acquire similar contractual rights.* Therefore, paragraph 25(b) of the IFRS confirms that *
This approach is consistent with the discussion of servicing rights and obligations in IAS 39.
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an insurer cannot introduce an accounting policy that measures those contractual rights at more than their fair value as implied by fees charged by others for comparable services; however, if an insurers existing accounting policies involve such measurements, it may continue to use them in phase I. BC130 The Boards agenda includes a project on revenue recognition.
Uniform accounting policies on consolidation

BC131 IAS 27 Consolidated and Separate Financial Statements requires entities to use uniform accounting policies. However, under current national requirements, some insurers consolidate subsidiaries without conforming the measurement of insurance liabilities using the subsidiaries own local GAAP to the accounting policies used by the rest of the group. BC132 The use of non-uniform accounting policies reduces the relevance and reliability of financial statements. However, prohibiting this would force some insurers to change their accounting policies for the insurance liabilities of some subsidiaries in phase I. This could have required systems changes that might no longer be needed in phase II. Therefore, the Board decided that an insurer already using non-uniform accounting policies for insurance contracts could continue to do so in phase I. However, if an insurer already uses uniform accounting policies for insurance contracts, it could not switch to a policy of using non-uniform accounting policies (paragraph 25(c) of the IFRS).
Excessive prudence
BC133 Insurers sometimes measure insurance liabilities on what is intended to be a highly prudent basis that lacks the neutrality required by the Framework. However, phase I does not define how much prudence is appropriate and cannot, therefore, eliminate excessive prudence. Consequently, the IFRS does not attempt to prohibit existing measurements of insurance liabilities that lack neutrality because of excessive prudence. Nevertheless, it prohibits the introduction of additional prudence if an insurer already measures insurance liabilities with sufficient prudence (see paragraph 26 of the IFRS). The liability adequacy test in paragraphs 15-19 addresses the converse problem of understated insurance liabilities.
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Future investment margins

BC134 In the Boards view, the cash flows from an asset are irrelevant for the measurement of a liability (unless those cash flows affect (a) the cash flows arising from the liability or (b) the credit characteristics of the liability). Many existing measurement practices for insurance liabilities conflict with this principle because they use a discount rate based on the estimated return from the assets that are deemed to back the insurance liabilities. However, the Board concluded that it could not eliminate these practices until phase II gives guidance on discount rates and the basis for risk adjustments. BC135 ED 5 stated that an accounting policy change makes financial statements less relevant and reliable if it introduces a practice of including future investment margins. On the following grounds, some respondents opposed this proposal, which would have prohibited the introduction of any measurements that reflect future investment margins: (a) The proposal prejudges a phase II issue. Most actuaries and insurers believe that a fair value measure (ie one calibrated to transactions involving insurance contracts) must include some consideration of asset performance because product pricing, reinsurance and market transactions are observed to reflect this feature. (b) A current market rate results in more relevant and reliable information than an out-of-date discount rate prescribed by a regulator, even if the current market rate reflects expected asset returns. (c) Asset-based discount rates are a feature of most existing national systems, including some modern systems that use current estimates of future cash flows and current (albeit asset-based) discount rates. The prohibition proposed in ED 5 would have prevented an insurer from replacing its existing accounting policies for insurance contracts with another comprehensive basis of accounting for insurance contracts that is, in aggregate, more relevant and reliable despite the disadvantage of using an asset-based discount rate. (d) Because US GAAP uses an asset-based discount rate for some insurance liabilities, the prohibition would have prevented insurers from adopting US GAAP for their insurance liabilities in phase I. This would have been unfair because some insurers that have already adopted IFRSs apply US GAAP to their insurance contracts and could continue to do so in phase I.
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BC136 In the light of these comments, the Board replaced the prohibition proposed in ED 5 with a rebuttable presumption, which could be overcome if the other components of a change in accounting policies increase the relevance and reliability of an insurers financial statements sufficiently to outweigh the disadvantage of introducing the practice in question (see paragraph 28 of the IFRS for an example). BC137 The IFRS identifies two practices that include future investment margins in the measurement of insurance liabilities: (a) using a discount rate that reflects the estimated return on the insurers assets,* (b) projecting the returns on those assets at an estimated rate of return, discounting those projected returns at a different rate and including the result in the measurement of the liability. Some suggested that (b) should be eliminated in phase I because they regarded it as less acceptable than (a). However, the Board noted that although (b) appears more obviously incorrect than (a), these two practices have the same effect and are logically equivalent.
Future investment margins and embedded value

BC138 In addition to considering asset-based discount rates in general, the Board also considered a specific measurement technique that, at least in present practice, typically reflects future investment margins, namely embedded value. Embedded value is an indirect method of measuring an insurance liability. Indirect methods measure the liability by discounting all cash flows arising from both the book of insurance contracts and the assets supporting the book, to arrive at a net measurement for the contracts and supporting assets. The measurement of the assets is then deducted to arrive at a measurement of the book of contracts. In contrast, direct methods measure the liability by discounting future
Some approaches attempt to find a portfolio of assets (replicating portfolio) with characteristics that replicate the characteristics of the liability very closely. If such a portfolio can be found, it may be appropriate to use the expected return on the replicating portfolio as the discount rate for the liability, with suitable adjustments for differences in their characteristics. However, replicating portfolio approaches should not be regarded as using an asset-based discount rate because they attempt to measure the characteristics of the liability. They are not based on the characteristics of the actual assets held, which may or may not match those of the liability. If embedded values are recognised in the balance sheet, they are typically presented as two components: an insurance liability and a separate intangible asset. This is similar to the expanded presentation that the IFRS permits in a business combination or portfolio transfer.
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cash flows arising from the book of insurance contracts only. If the same assumptions are made in both methods, direct and indirect methods can produce the same results.* BC139 Life insurers in an increasing number of countries disclose embedded value information. Most disclose this information outside the financial statements or as supplementary information (usually unaudited), but a few use it as a measurement in their balance sheets. BC140 Some respondents felt that embedded value methodology is far more relevant and reliable than most local accounting methods, and insurers should be permitted to adopt it. They noted that embedded values are often an important consideration in determining prices for acquisitions of insurers and of blocks of insurance contracts. Furthermore, embedded value and similar indirect methods are often used in accounting for the insurance liabilities assumed in these acquisitions. BC141 For the following reasons, some suggested that phase I should prohibit embedded value measurements in the balance sheet. (a) Embedded value approaches are largely unregulated at present and there is diversity in their application. For example, some view the methods used to reflect risk as fairly crude, diverse and not always fully consistent with capital market prices. (b) Embedded value methods today typically involve two practices whose introduction ED 5 regarded as unacceptable: (i) reflecting future investment margins in the measurement of the embedded value asset associated with insurance liabilities (see paragraphs BC134-BC144). measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current fees charged by other market participants for similar services (see paragraphs BC128-BC130).
(ii)
(c) In current practice, embedded values are generally determined on a single best estimate basis that does not reflect the full range of possible outcomes. This does not generally adequately address embedded guarantees and options, such as embedded interest rate guarantees. Until recently, embedded values would have ignored
Luke N. Girard, Market Value of Insurance Liabilities: Reconciling the Actuarial Appraisal and Option Pricing Methods, North American Actuarial Journal, Volume 4, Number 1
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these items if they were out of the money. Indeed, in some cases, they might have been ignored even if they were in the money, because of assumptions about future investment performance. More attention is now being devoted to these options and guarantees and embedded value methods may begin to address them more rigorously, but that development is not yet complete. BC142 However, for the following reasons, the IFRS permits continued use of embedded value measurements: (a) One objective of phase I is to avoid disturbing existing practice for insurance contracts, unless a change creates a significant improvement and leads in a direction consistent with the likely direction of phase II. Prohibiting the continued use of embedded values would not meet that criterion. (b) Embedded value methods are based on estimates of future cash flows, not an accumulation of past transactions. The advantages of this may, in some cases, outweigh the disadvantage of including future investment margins. Therefore, eliminating embedded value methods may not result in more relevant and reliable financial statements in every case. (c) Given that the Board did not prohibit asset-based discount rates for other measurements of insurance liabilities in phase I, there is no compelling reason in phase I to prohibit embedded value measurements that contain future investment margins. (d) Although embedded value measurements today typically include future investment margins, some practitioners have suggested improving embedded value methods by adjusting the asset cash flows fully for risk to make them consistent with market prices. BC143 It follows from the Boards conclusions on relevance and reliability (paragraphs BC123-BC125), investment management fees (paragraphs BC128-BC130) and future investment margins (paragraphs BC134-BC137) that an insurer can introduce embedded value measurements in its balance sheet only if all the following conditions are met: (a) the new accounting policy will result in more relevant and reliable financial statements (paragraph 22 of the IFRS). This is not an automatic decision and will depend on a comparison of the insurers existing accounting with the way in which it intends to apply embedded value.
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(b) this increase in relevance and reliability is sufficient to overcome the rebuttable presumption against including future investment margins (paragraph 29 of the IFRS). (c) the embedded values include contractual rights to future investment management fees at an amount that does not exceed their fair value as implied by a comparison with current fees charged by other market participants for similar services (paragraph 25(b) of the IFRS and paragraphs BC128-BC130). BC144 In some measurement approaches, the discount rate is used to determine the present value of a future profit margin, which is then attributed to different periods using a formula. However, in other approaches (such as most applications of embedded value), the discount rate determines the measurement of the liability directly. The Board concluded that it is highly unlikely that an insurer could overcome the rebuttable presumption in the latter case (see paragraph 29 of the IFRS).
Redesignation of financial assets

BC145 When an insurer changes its accounting policies for insurance liabilities, it is permitted, but not required, to reclassify some or all financial assets as at fair value through profit or loss. This permits an insurer to avoid artificial mismatches when it improves its accounting policies for insurance liabilities. The Board also decided: (a) not to restrict redesignation to assets backing the insurance contracts for which the accounting policies were changed. The Board did not wish to create unnecessary barriers for those insurers that wish to move to a more consistent measurement basis that reflects fair values. (b) not to introduce an option to reclassify financial assets as available for sale. Such reclassification would have caused changes in carrying amount to be recognised directly in equity for assets, but in profit or loss for insurance liabilities. An insurer can avoid this inconsistency by classifying the financial assets as at fair value through profit or loss. BC146 IAS 39 permits redesignation of assets in specified circumstances when an entity adopts the revised IAS 39. IFRS 1 First-time Adoption of International Financial Reporting Standards contains corresponding provisions for first-time adopters.
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ACQUISITION OF INSURANCE CONTRACTS IN BUSINESS COMBINATIONS AND PORTFOLIO TRANSFERS

BC147 When an entity acquires another entity in a business combination, IFRS 3 Business Combinations requires the acquirer to measure at fair value the identifiable assets and liabilities acquired. Similar requirements exist under many national accounting frameworks. Nevertheless, in practice, insurers have often used an expanded presentation that splits the fair value of acquired insurance contracts into two components: (a) a liability measured in accordance with the insurers accounting policies for insurance contracts that it issues; and (b) an intangible asset, representing the difference between (i) the fair value of the contractual insurance rights acquired and insurance obligations assumed and (ii) the amount described in (a). Life insurers often describe this intangible asset by names such as the present value of in force business (PVIF), present value of future profits (PVFP or PVP) or value of business acquired (VOBA). Similar principles apply in non-life insurance, for example if claims liabilities are not discounted. BC148 For the following reasons, the Board decided to permit these existing practices during phase I (paragraph 31 of the IFRS): (a) One objective of phase I is to avoid prejudging most phase II issues and to avoid requiring systems changes for phase I that might need to be reversed for phase II. In the meantime, disclosure about the nature of, and changes in, the related intangible asset provides transparency for users. (b) The IFRS gives no guidance on how to determine the fair value of the insurance liabilities, because that would be premature in phase I. Thus, fair values identified during phase I might need to be changed in phase II. (c) It may be difficult to integrate a fair value measurement at the date of a business combination into subsequent insurance contract accounting without requiring systems changes that could become obsolete in phase II. BC149 The intangible asset described above is generally amortised over the estimated life of the contracts. Some insurers use an interest method of amortisation, which appears appropriate for an asset that essentially comprises the present value of a set of contractual cash flows. However,
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it is doubtful whether IAS 38 Intangible Assets would have permitted its use. Therefore, the Board decided that this asset should remain outside the scope of IAS 38 and its subsequent measurement should be consistent with the measurement of the related insurance liability (paragraph 31(b) of the IFRS). Because this asset would be covered by the liability adequacy test in paragraphs 15-19, the Board also excluded it from the scope of IAS 36 Impairment of Assets. BC150 IAS 36 and IAS 38 still apply to customer lists and customer relationships reflecting the expectation of contracts that are not part of the contractual insurance rights and contractual insurance obligations that existed at the date of a business combination. An illustrative example published with IFRS 3 deals with customer relationships acquired together with a portfolio of one-year motor insurance contracts. BC151 Measurements of the intangible asset described in paragraph BC147(b) sometimes include future investment margins. Those margins are subject to the same requirements as future investment margins included in the measurement of the related insurance liability (see paragraphs BC134-BC144). BC152 In some cases, an insurers accounting policies under previous GAAP (ie those used before it adopted IFRSs) involved measuring the intangible asset described in paragraph BC147(b) on a basis derived from the carrying amounts of other assets and liabilities. In such cases, if an entity changes the measurements of its assets and liabilities on adopting IFRSs for the first time, shadow accounting may become relevant (see paragraphs BC181-BC184 for a discussion of shadow accounting). BC153 Some respondents requested an exemption from fair value measurement for insurance liabilities assumed in a business combination. They argued that there is still too much uncertainty about how fair value should be defined and determined. However, insurers have apparently been able to cope with the existing requirements in IFRSs and in national standards. The Board saw no compelling reason for a new exemption.
DISCRETIONARY PARTICIPATION FEATURES

BC154 Some insurance contracts contain a discretionary participation feature as well as a guaranteed element. The insurer has discretion over the amount and/or timing of distributions to policyholders, although that discretion may be subject to some contractual constraints (including related legal and regulatory constraints) and competitive constraints. Distributions are
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typically made to policyholders whose contracts are still in force when the distribution is made. Thus, in many cases, a change in the timing of a distribution means that a different generation of policyholders will benefit. BC155 Although the issuer has contractual discretion over distributions, it is usually likely that current or future policyholders will ultimately receive some part of the accumulated surplus available, at the reporting date, for distribution to holders of contracts with discretionary participation features (ie distributable surplus). The main accounting question is whether that part of the distributable surplus is a liability or a component of equity. The Board will explore that question in phase II. BC156 Features of this kind are found not only in insurance contracts but also in some investment contracts (ie financial liabilities). Requiring a particular accounting treatment in phase I for investment contracts with these features would create the risk that the Board might decide on a different treatment in phase II. Furthermore, in some cases, holders of insurance contracts and investment contracts have a contractual right to share in discretionary payments out of the same pool of assets. If the Board required a particular treatment for the discretionary participation features of the investment contracts in phase I, it might prejudge the treatment of these features in insurance contracts that are linked to the same pool of assets. BC157 For these reasons, the Board decided not to address most aspects of the accounting treatment of such features in phase I, in either insurance contracts or investment contracts. However, paragraphs 34 and 35 of the IFRS confirm that it is unacceptable to classify a discretionary participation feature as an intermediate category that is neither liability nor equity, because this would be inconsistent with the Framework. If a balance sheet item does not meet the Frameworks definition of, and recognition criteria for, assets or liabilities, that item is included in equity. BC158 Furthermore, ED 5 proposed a requirement for the issuer of an investment contract containing such a feature to recognise a liability measured at no less than the amount that would result from applying IAS 39 to the guaranteed element of the contract. Because issuers need not determine the IAS 39 measurement of the guaranteed element if the total recognised liability is clearly higher, ED 5 noted the Boards expectation that issuers would not need extensive new systems to comply with this requirement. BC159 Some respondents objected that determining the result of applying IAS 39 to the guaranteed element would either have virtually no effect (in which case the requirement would be unnecessary) or require extensive new systems (causing costs exceeding the likely benefit to users). In finalising the IFRS, the Board adopted a more flexible approach
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that limits the need for systems to apply IAS 39 to the guaranteed element alone, while still requiring some rigour to avoid the understatement of the financial liability. Specifically, paragraph 35 permits two approaches for a discretionary participation feature in a financial liability: (a) The issuer may classify the entire discretionary participation feature as a liability, but need not separate it from the guaranteed element (and so need not determine the result of applying IAS 39 to the guaranteed element). An issuer choosing this approach is required to apply the liability adequacy test in paragraphs 15-19 of the IFRS to the contract. (b) The issuer may classify part or all of the feature as a separate component of equity. If so, the liability recognised cannot be less than the result of applying IAS 39 to the guaranteed element. The issuer need not determine that measurement if the total liability recognised is clearly higher. BC160 There may be timing differences between accumulated profits under IFRSs and distributable surplus (ie the accumulated amount that is contractually eligible for distribution to holders of discretionary participation features). For example, distributable surplus may exclude unrealised investment gains that are recognised under IFRSs. The resulting timing differences are analogous, in some respects, to temporary differences between the carrying amounts of assets and liabilities and their tax bases. The IFRS does not address the classification of these timing differences because the Board will not determine until phase II whether the distributable surplus is all equity, all liability or part equity and part liability. BC161 The factor that makes it difficult to determine the appropriate accounting for these features is constrained discretion, in other words, the combination of discretion and constraints on that discretion. If participation features lack discretion, they are embedded derivatives and within the scope of IAS 39. BC162 The definition of a discretionary participation feature does not capture an unconstrained contractual discretion to set a crediting rate that is used to credit interest or other returns to policyholders (as found in the contracts described in some countries as universal life contracts). Some view these features as similar to discretionary participation features because crediting rates are constrained by market forces and the insurers resources. The Board will revisit the treatment of these features in phase II.
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BC163 Some respondents asked the Board to clarify the treatment of premiums received for financial instruments containing discretionary participation features. Conceptually the premium for the guaranteed element is not revenue, but the treatment of the premium for the discretionary participation feature could depend on matters that will not be resolved until phase II. Furthermore, requiring the premium to be split could involve system changes that might become redundant in phase II. To avoid unnecessary disruption in phase I, the Board decided that entities could continue presenting premiums as revenue, with a corresponding expense representing the change in the liability. BC164 Conceptually, if part or all of a discretionary participation feature is classified as a component of equity, the related portion of the premium should not be included in profit or loss. However, the Board concluded that requiring each incoming premium to be split would require systems changes beyond the scope of phase I. Therefore, the Board decided that an issuer could recognise the entire premium as revenue without separating the portion that relates to the equity component. However, the Board confirmed that the portion of profit or loss attributable to the equity component is presented as an allocation of profit or loss (in a manner similar to the presentation of minority interests), not as expense or income. BC165 Some suggested that investment contracts containing a discretionary participation feature should be excluded from the fair value disclosure required by IAS 32. They noted both conceptual and practical problems in determining the fair value of an instrument of this kind. However, instead of creating a new exclusion from the required disclosure of fair value, the Board added new paragraph 91A to IAS 32. This extends existing requirements in IAS 32 governing those unquoted equity instruments whose fair value cannot be determined reliably.
ISSUES RELATED TO IAS 39 Assets held to back insurance contracts

BC166 The IFRS does not address financial or non-financial assets held by insurers to back insurance contracts. IAS 39 identifies four categories of financial asset, with three different accounting treatments. In developing IAS 39, the Boards predecessor (IASC) acknowledged that most countries had a mixed measurement model, measuring some financial assets at amortised cost and others at fair value. IASC decided to retain, but regulate and structure, the different approaches as follows:
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(a) financial assets classified as at fair value through profit or loss (including all financial assets held for trading) are measured at fair value, with all changes in their fair value recognised in profit or loss. Furthermore, all derivatives are deemed to be held for trading, and hence measured at fair value, because this is the only method that provides sufficient transparency in the financial statements. (b) available-for-sale assets (ie those that do not fall into any of the other categories) are measured at fair value, with changes in their fair value recognised in equity until the asset is derecognised or becomes impaired. Measurement at fair value is appropriate given that available-for-sale assets may be sold in response to, for example, changes in market prices or a liquidity shortage. (c) assets with a fixed maturity may be measured at amortised cost if the entity intends to hold them to maturity and shows that it has the ability to do so. This treatment is based on the view of some that changes in market prices are irrelevant if an asset is held to maturity because those changes will reverse before maturity (unless the asset becomes impaired). (d) loans and receivables are measured at amortised cost. IASC was persuaded that there are difficulties in estimating the fair value of such loans, and that further progress was needed in valuation techniques before fair value should be required. BC167 Some expressed concerns that accounting mismatches would arise in phase I if financial assets (particularly interest-bearing investments) held to back insurance contracts are measured at fair value under IAS 39 whilst insurance liabilities are measured on a different basis. If the insurer classifies the assets as available for sale, this difference in measurement basis would not affect profit or loss but it could lead to some volatility in equity. Some do not regard that volatility as a faithful representation of changes in the insurers financial position. In developing ED 5, after discussing various suggestions for reducing that volatility,* the Board decided: (a) not to relax the criteria in IAS 39 for classifying financial assets as held to maturity. Relaxing those criteria would undermine the fundamental assertion that an entity has both the intent and ability to hold the assets until maturity. The Board noted that an insurer may *
The Board discussed this subject at its meeting in November 2002. It was also one of the major topics raised by insurance participants at two half-day sessions during the financial instruments round-tables in March 2003. Before finalising ED 5, the Board discussed the subject again in April 2003.
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be able to classify some of its fixed maturity financial assets as held to maturity if it intends not to sell them before maturity and, in addition to meeting the other conditions set out in IAS 39, concludes that an unexpected increase in lapses or claims would not compel it to sell those assets (except in the disaster scenario discussed in IAS 39 paragraph AG21). (b) not to create a new category of assets carried at amortised cost: assets held to back insurance liabilities. The creation of such a category would lead to a need for arbitrary distinctions and complex attribution procedures that would not make an insurers financial statements more relevant and reliable, and could require insurers to develop costly systems. The Board reviewed a precedent that exists in Japan for such a category, but was not persuaded that the procedures adopted there can overcome these difficulties. Moreover, if an insurer may sell assets in response to, for example, changes in market prices or a liquidity shortage, the only appropriate measurement is fair value. (c) not to create a new category of available-for-settlement liabilities, analogous to available-for-sale assets, measured at fair value, with changes in fair value recognised in equity. The creation of such a category would make it necessary to find some basis for distinguishing between that category and the existing category of non-trading financial liabilities, or to permit a free choice of accounting treatments. The Board has identified no basis for such a distinction, nor for deciding which of these two categories would be the new residual category. Furthermore, creating such a category could require insurers to develop new systems with no certainty that those systems would be needed in phase II. BC168 In developing ED 5, the Board concluded that the reasons given above outweigh the effects of any accounting mismatch on an insurers reported equity. Therefore, the Board decided not to exempt insurers from these existing requirements, even temporarily. BC169 Insurers may be particularly sensitive to equity reported in general purpose financial statements in some countries where this amount is used in assessing compliance with regulatory capital requirements. However, although insurance supervisors are important users of general purpose financial statements, those financial statements are not directed at specific needs of insurance supervisors that other users do not share. Furthermore, supervisors generally have the power to obtain additional information that meets their specific needs. In the Boards view, creating
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new exemptions from IAS 39 in this area would not have been the best way to meet the common needs of users (including insurance supervisors) of an insurers general purpose financial statements. BC170 Some argued that banks enjoy an advantage that is not available to insurers. Under IAS 39, a bank may measure its core banking-book assets and liabilities (loans and receivables and non-trading financial liabilities) at amortised cost, whereas an insurer would have no such option for many of the assets held to back its core insurance activities. However, as noted in paragraph BC166(d), IASC permitted amortised cost measurement for loans and receivables because it had concerns about difficulties in establishing their fair value. This factor does not apply to many assets held by insurers to back insurance liabilities. BC171 Many of the respondents to ED 5 urged the Board to explore ways of reducing the accounting mismatch described above. The Board discussed this subject at length at all three meetings at which it discussed the responses to ED 5 before finalising the IFRS. In addition, the Board discussed it with the Standards Advisory Council. It was also raised at a meeting of the Boards Insurance Advisory Committee in September 2003, which six Board members attended together with the project staff. Individual Board members and staff also had many discussions with interested parties, including users, insurers, actuaries, auditors and regulators. BC172 It is important to distinguish two different types of mismatch: (a) accounting mismatch arises if changes in economic conditions affect assets and liabilities to the same extent, but the carrying amounts of those assets and liabilities do not respond equally to those economic changes. Specifically, accounting mismatch occurs if an entity uses different measurement bases for assets and liabilities. (b) economic mismatch arises if the values of, or cash flows from, assets and liabilities respond differently to changes in economic conditions. It is worth noting that economic mismatch is not necessarily eliminated by an asset-liability management programme that involves investing in assets to provide the optimal risk-return trade-off for the package of assets and liabilities. BC173 Ideally, a measurement model would report all the economic mismatch that exists and would not report any accounting mismatch. The Board considered various alternatives, observing that all had advantages and disadvantages. Some alternatives would have amended IAS 39 to extend the use of cost or amortised cost measurements. However, the Board noted the following:
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(a) Fair value is a more relevant measurement than amortised cost for financial assets that an entity might sell in response to changing market and other conditions. (b) In its response to ED 5, the Association for Investment Management and Research (AIMR) strongly urged the Board not to extend the use of amortised cost in IAS 39. The AIMR is a non-profit professional association of more than 67,200 financial analysts, portfolio managers, and other investment professionals in 116 countries. (c) An accounting model that measured both assets and liabilities at amounts based on current interest rates would provide information about the degree of economic mismatch. A model that measured both at historical values, or ignored the time value of money in measuring some insurance liabilities, would not. Financial analysts often observe that information about economic mismatch is very important to them. (d) Some suggested that insurers wish to follow a strategy that involves holding fixed maturity investments to maturity, with some flexibility to sell investments if insurance claims or lapses are unusually high. They recommended relaxing restrictions in IAS 39 so that insurers using such a strategy could use the held-to-maturity category more easily. However, in discussions with individual Board members and staff, insurers generally indicated that they also wished to keep the flexibility to make sales in the light of changing demographic and economic conditions so that they can seek the best trade-off between risk and return. That is a valid and understandable business objective, but it is difficult to argue that cost could be more relevant than fair value in such cases. Although IAS 32 requires disclosure of the fair value of financial assets carried at amortised cost, disclosure does not rectify inappropriate measurement. (e) Some noted that they wished to keep the flexibility to sell corporate bonds before a major downgrade occurs. They viewed the guidance in IAS 39 as restricting their ability to do this. Moreover, because a tainting requirement in IAS 39 prohibits the use of the held-to-maturity category after most sales from this category, insurers are reluctant to use this classification for corporate bonds. The application guidance in IAS 39 gives examples of cases when sales of held-to-maturity investments do not taint all other such investments. For example, paragraph AG22(a) of IAS 39 refers to a sale following a significant deterioration in the issuers creditworthiness. The Board noted that some appeared to read that
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guidance as limited to changes in a credit rating by an external credit rating agency, although the guidance also refers to internal ratings that meet particular criteria. (f) The Japanese precedent mentioned in paragraph BC167(b) creates some discipline by placing restrictions on the use of amortised cost, but for systems or other reasons not all insurers in Japan adopt this approach. Furthermore, this approach permits a cost approach if the durations (ie average maturities) of insurance liabilities match those of the related assets within a specified band of 80-125 per cent. If any economic mismatch arises within that band, this approach does not recognise it. In addition, gains and losses on selling assets held at amortised cost are generally recognised immediately in profit or loss (except that some gains are deferred and amortised if sales are not compatible with the duration matching strategy). (g) Some Board members and staff met representatives of major European insurers to explore the possibility of (i) extending the use of amortised cost if specified, relatively strict, criteria are met and (ii) combining that with a simplified attempt to identify ineffectiveness resulting from the fact that the assets and liabilities would not respond identically to changes in interest rates. This approach would have avoided some of the practical and conceptual problems inherent in the Japanese approach discussed above. However, this untried approach had been developed at short notice and not all details had been worked through. Moreover, many insurers may not be able or willing to invest in systems that could need amendment in phase II. (h) That a mixed measurement model can create an accounting mismatch is undeniable. Furthermore, it costs time and money for insurers to explain the effects even to sophisticated users. Insurers are very concerned that less sophisticated users may misinterpret the resulting information. If a simple, transparent and conceptually acceptable way could have been found to eliminate the accounting mismatch at an acceptable cost without also obscuring the economic mismatch, that change might have been beneficial. However, the Board could find no such way in the short term. The Board also noted that any change could have required major systems changes and that there appeared to be no consensus among insurers on a single method. (i) Extending the use of amortised cost would have created an inconsistency with US GAAP. The accounting mismatch described in paragraphs BC167 and BC172 has existed for some years in
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US GAAP, which requires insurers to account for their financial assets in broadly the same way as under IAS 39. Furthermore, the US Financial Accounting Standards Board decided in January 2004 not to add to its agenda a project to reconsider US GAAP for investments held by life insurance companies. BC174 In the light of these considerations, the Board concluded that changing the measurement requirements in IAS 39 for financial assets, even temporarily, would diminish the relevance and reliability of an insurers financial statements. The Board observed that the accounting mismatch arose more from imperfections in existing measurement models for insurance liabilities than from deficiencies in the measurement of the assets. It would have been a retrograde step to try to mitigate the accounting mismatch by adopting a less relevant measurement of the assetsa measurement that would also have obscured some of the economic mismatch. BC175 The Board considered whether it could mitigate the accounting mismatch by permitting improvements to the measurement of insurance liabilities. The Board noted that introducing a current market-based discount rate for insurance liabilities rather than a historical discount rate would improve the relevance and reliability of an insurers financial statements. Therefore, such a change would have been permitted by the proposals in ED 5 and is also permitted by the IFRS. However, IAS 8 requires consistent accounting policies for similar transactions. For systems and other reasons, some insurers may not wish, or be able, in phase I to introduce a current market-based discount rate for all insurance liabilities. BC176 The Board concluded that the increase in relevance and reliability from introducing a current discount rate could outweigh the disadvantages of permitting accounting policies that are not applied consistently to all similar liabilities. Accordingly, the Board decided to permit, but not require, an insurer to change its accounting policies so that it remeasures designated insurance liabilities for changes in interest rates. This election permits a change in accounting policies that is applied to some liabilities, but not to all similar liabilities as IAS 8 would otherwise require. The Board noted that insurers might sometimes be able to develop simplified models that give a reasonable estimate of the effect of interest rate changes. BC177 The Board also noted the following: (a) No single proposal would have eliminated the accounting mismatch for a broad cross-section of insurers without also obscuring the economic mismatch. (b) No single proposal would have been acceptable to a broad cross-section of insurers.
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(c) No single proposal could have been implemented by a broad cross-section of insurers without major systems changes. In other words, no solution was available that built on common industry approaches and systems. Furthermore, the systems needed to implement successfully the approach discussed with some European insurers (see paragraph BC173(g)) would also allow the approach permitted by paragraph 24 of the IFRS (adjusting designated liabilities for changes in interest rates). Indeed, paragraph 24 imposes fewer restrictions than the approach discussed with European insurers because it does not require the assets to match the liability cash flows closely, since any mismatch in cash flows is reflected in profit or loss. (d) Adjusting the discount rate for designated liabilities will not eliminate all the accounting mismatch described above and some, perhaps many, insurers will choose not to make that adjustment. The reasons for this are as follows: (i) As noted above, many insurers may not have systems to adjust liabilities for changes in interest rates and may not wish to develop such systems, even for designated liabilities as opposed to all liabilities. Changes in discount rates would not affect the measurement of insurance liabilities that are carried at an accumulated account value. Changes in discount rates would not affect the measurement of financial liabilities with a demand feature, because IAS 39 states that their fair value is not less than the amount payable on demand (discounted, if applicable, from the first date when that amount could be required to be paid). Although this last point is not strictly relevant for insurance contracts, many life insurers issue investment contracts for which it is relevant.
(ii)
(iii)
BC178 In summary, the Board decided not to amend existing measurement requirements in IAS 39 for financial assets because such amendments would have reduced the relevance and reliability of financial statements to an unacceptable extent. Although such amendments could have eliminated some of the accounting mismatch, they would also have obscured any economic mismatch that exists. The following points summarise amendments made to ED 5 that might mitigate the accounting mismatch in some cases, as well as relevant observations made by the Board:
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(a) The Board decided to permit, but not require, an insurer to change its accounting policies so that it remeasures designated insurance liabilities for changes in interest rates (see paragraph BC176). (b) The Board clarified the applicability of the practice sometimes known as shadow accounting (paragraphs BC181-BC184). (c) The Board amended IAS 40 Investment Property to permit two separate elections when an entity selects the fair value model or the cost model for investment property. One election is for investment property backing contracts (which could be either insurance contracts or financial instruments) that pay a return linked directly to the fair value of, or returns from, specified assets including that investment property. The other election is for all other investment property (see paragraph C12 of the IFRS). (d) The Board observed that some entities appeared to have misread the application guidance in IAS 39 on sales of held-to-maturity investments following a significant deterioration in the issuers creditworthiness. Specifically, as noted in paragraph 173(e), some appeared to have read it as limited to changes in a credit rating by an external credit rating agency, although the guidance also refers to internal ratings that meet particular criteria. (e) The Board observed that IAS 1 and IAS 32 do not preclude a presentation identifying a separate component of equity to report a portion of the change (and cumulative change) in the carrying amount of fixed-maturity available-for-sale financial assets. An insurer could use such a presentation to highlight the effect on equity of changes in interest rates that (i) changed the carrying amount of assets but (ii) did not change the carrying amount of liabilities that respond economically to those changing interest rates. BC179 IAS 40 permits an entity to use a fair value model for investment property, but IAS 16 does not permit this model for owner-occupied property. An entity may measure its owner-occupied property at fair value using the revaluation model in IAS 16, but changes in its fair value must be recognised in revaluation surplus rather than in profit or loss. Some insurers regard their owner-occupied property as an investment and prefer to use a fair value model for it. However, the Board decided not to make piecemeal changes to IAS 16 and IAS 40 at this stage. BC180 The Board noted that shadow accounting (paragraphs BC181-BC184) may be relevant if there is a contractual link between payments to policyholders and the carrying amount of, or returns from, owner-occupied property. If an insurer elects to use shadow accounting,
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changes in the measurement of the liability resulting from revaluations of the property are recognised directly in equity, through the statement of changes in equity.
Shadow accounting
BC181 In some accounting models, realised gains or losses on an insurers assets have a direct effect on the measurement of some or all of its insurance liabilities.* BC182 When many of those models were constructed, unrealised gains and most unrealised losses were not recognised in financial statements. Some of those models were extended later to require some financial assets to be measured at fair value, with changes in fair value recognised directly in equity (ie the same treatment as for available-for-sale financial assets under IAS 39). When this happened, a practice sometimes known as shadow accounting was developed with the following two features: (a) A recognised but unrealised gain or loss on an asset affects the measurement of the insurance liability in the same way that a realised gain or loss does. (b) If unrealised gains or losses on an asset are recognised directly in equity, the resulting change in the carrying amount of the insurance liability is also recognised in equity. BC183 Some respondents asked the Board to clarify whether the proposals in ED 5 permitted shadow accounting. The Board concluded the following: (a) In principle, gains and losses on an asset should not influence the measurement of an insurance liability (unless the gains or losses on the asset alter the amounts payable to policyholders). Nevertheless, this is a feature of some existing measurement models for insurance liabilities and the Board decided that it was not feasible to eliminate this practice in phase I (see paragraph BC134 for further discussion in the context of future investment margins). (b) Shadow accounting permits all recognised gains and losses on assets to affect the measurement of insurance liabilities in the same way, regardless of whether (i) the gains and losses are realised or
Throughout this section, references to insurance liabilities are also relevant for (a) related deferred acquisition costs and (b) intangible assets relating to insurance contracts acquired in a business combination or portfolio transfer.
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unrealised and (ii) unrealised gains and losses are recognised in profit or loss or directly in equity. This is a logical application of a feature of some existing models. (c) Because the Board does not expect that feature of existing models to survive in phase II, insurers should not be required to develop systems to apply shadow accounting. (d) If an unrealised gain or loss on an asset triggers a shadow accounting adjustment to a liability, that adjustment should be recognised in the same way as the unrealised gain or loss. (e) In some cases and to some extent, shadow accounting might mitigate volatility caused by differences between the measurement basis for assets and the measurement basis for insurance liabilities. However, that is a by-product of shadow accounting and not its primary purpose. BC184 Paragraph 30 of the IFRS permits, but does not require, shadow accounting. The Implementation Guidance includes an illustrative example to show how shadow accounting might become relevant in an environment where the accounting for assets changes so that unrealised gains are recognised (IG Example 4). Because the Board does not expect the feature underlying the use of shadow accounting to survive in phase II, the Board decided not to give further guidance.
Investment contracts
BC185 Many insurers issue investment contracts (ie financial instruments that do not transfer enough insurance risk to qualify as insurance contracts). Under IAS 39, the issuer measures investment contracts at either amortised cost or, with appropriate designation at inception, at fair value. Some aspects of the measurements under IAS 39 differ from the measurements that are often used at present under national accounting requirements for these contracts: (a) The definition and treatment of transaction costs under IAS 39 may differ from the definition and treatment of acquisition costs in some national requirements. (b) The condition in IAS 39 for treating a modification of a financial liability (or the exchange of the new liability for an old liability) as an extinguishment of the original liability may differ from equivalent national requirements.
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(c) Future cash flows from assets do not affect the amortised cost or fair value of investment contract liabilities (unless the cash flows from the liabilities are contractually linked to the cash flows from the assets). (d) The amortised cost of a financial liability is not adjusted when market interest rates change, even if the return on available assets is below the effective interest rate on the liability (unless the change in rates causes the liability cash flows to change). (e) The fair value of a financial liability with a demand feature is not less than the amount payable on demand. (f) The fair value of a financial instrument reflects its credit characteristics.
(g) Premiums received for an investment contract are not recognised as revenue under IAS 39, but as balance sheet movements, in the same way as a deposit received. BC186 Some argued that the Board should not require insurers to change their accounting for investment contracts in phase I because the scope of phase I is intended to be limited and because the current treatment of such contracts is often very similar to the treatment of insurance contracts. However, the Board saw no reason to delay the application of IAS 39 to contracts that do not transfer significant insurance risk. The Board noted that some of these contracts have features, such as long maturities, recurring premiums and high initial transaction costs, that are less common in other financial instruments. Nevertheless, applying a single set of accounting requirements to all financial instruments will make an insurers financial statements more relevant and reliable. BC187 Some contracts within the scope of IAS 39 grant cancellation or renewal rights to the holder. The cancellation or renewal rights are embedded derivatives and IAS 39 requires the issuer to measure them separately at fair value if they are not closely related to their host contract (unless the issuer elects to measure the entire contract at fair value).
Embedded derivatives
BC188 Some suggested that the Board should exempt insurers from the requirement to separate embedded derivatives contained in a host insurance contract and measure them at fair value under IAS 39. They argued that:
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(a) separating these derivatives would require extensive and costly systems changes that might not be needed for phase II. (b) some of these derivatives are intertwined with the host insurance contract in a way that would make separate measurement arbitrary and perhaps misleading, because the fair value of the whole contract might differ from the sum of the fair values of its components. BC189 Some suggested that the inclusion of embedded options and guarantees in the cash flows used for a liability adequacy test could permit the Board to exempt some embedded derivatives from fair value measurement under IAS 39. Most proponents of this exemption implied that including only the intrinsic value of these items (ie without their time value) would suffice. However, because excluding the time value of these items could make an entitys financial statements much less relevant and reliable, the Board did not create such an exemption. BC190 In the Boards view, fair value is the only relevant measurement basis for derivatives, because it is the only method that provides sufficient transparency in the financial statements. The cost of most derivatives is nil or immaterial. Hence if derivatives were measured at cost, they would not be included in the balance sheet and their success (or otherwise) in reducing risk, or their role in increasing risk, would not be visible. In addition, the value of derivatives often changes disproportionately in response to market movements (put another way, they are highly leveraged or carry a high level of risk). Fair value is the only measurement basis that can capture this leveraged nature of derivativesinformation that is essential to communicate to users the nature of the rights and obligations inherent in derivatives. BC191 IAS 39 requires entities to account separately for derivatives embedded in non-derivative contracts. This is necessary: (a) to ensure that contractual rights and obligations that create similar risk exposures are treated in the same way whether or not they are embedded in a non-derivative contract. (b) to counter the possibility that entities might seek to avoid the requirement to measure derivatives at fair value by embedding a derivative in a non-derivative contract. BC192 The requirement to separate embedded derivatives already applied to a host contract of any kind before the IFRS was issued. Exempting insurance contracts from that existing requirement would have been a retrograde step. Furthermore, much of the effort needed to measure embedded derivatives at fair value arises from the need to identify the
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derivatives and from other steps that will still be needed if the Board requires fair value measurement for phase II. In the Boards view, the incremental effort needed to identify the embedded derivatives separately in phase I is relatively small and is justified by the increased transparency that fair value measurement brings. IG Example 2 in the Implementation Guidance gives guidance on the treatment of various forms of embedded derivative. BC193 Some embedded derivatives meet the definition of an insurance contract. It would be contradictory to require a fair value measurement in phase I of an insurance contract that is embedded in a larger contract when such measurement is not required for a stand-alone insurance contract. Therefore, the IFRS confirms that this is not required (paragraph 8). For the same reason, the Board concluded that an embedded derivative is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately (see new paragraph AG33(h) of IAS 39). Without this conclusion, paragraph 12 of IAS 39 would have required the insurer to measure the entire contract at fair value. An alternative approach would have been to retain that requirement, but require measurement at cost if an insurance contract cannot be measured reliably at fair value in its entirety, building on a similar treatment in IAS 39 for unquoted equity instruments. However, the Board did not intend to require fair value measurement for insurance contracts in phase I. Therefore, the Board decided not to require this even when it is possible to measure reliably the fair value of an insurance contract containing an embedded derivative. BC194 The Board acknowledges that insurers need not, during phase I, recognise some potentially large exposures to items such as guaranteed annuity options and guaranteed minimum death benefits. These items create risks that many regard as predominantly financial, but if the payout is contingent on an event that creates significant insurance risk, these embedded derivatives meet the definition of an insurance contract. The IFRS requires specific disclosures about these items (paragraph 39(e)). In addition, the liability adequacy test requires an entity to consider them (see paragraphs BC94-BC104).
Elimination of internal items

BC195 Some respondents suggested that financial instruments issued by one entity to a life insurer in the same group should not be eliminated from the groups consolidated financial statements if the life insurers assets are earmarked as security for policyholders savings.
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BC196 The Board noted that these financial instruments are not assets and liabilities from the groups perspective. The Board saw no justification for departing from the general principle that all intragroup transactions are eliminated, even if they are between components of an entity that have different stakeholders, for example policyholder funds and shareholder funds. However, although the transactions are eliminated, they may affect future cash flows. Hence, they may be relevant in measuring liabilities. BC197 Some respondents argued that non-elimination would be consistent with the fact that financial instruments issued can (unless they are non-transferable) be plan assets in defined benefit plans under IAS 19 Employee Benefits. However, the Board did not view IAS 19 as a precedent in this area. IAS 19 requires a presentation net of plan assets because investment in plan assets reduces the obligation (IAS 19 Basis for Conclusions paragraph 66). This presentation does not result in the recognition of new assets and liabilities.
INCOME TAXES
BC198 Some respondents argued that discounting should be required, or at least permitted, for deferred tax relating to insurance contracts. The Board noted that discounting of a temporary difference is not relevant if an items tax base and carrying amount are both determined on a present value basis.
DISCLOSURE
BC199 The disclosure requirements are designed as a pair of high level principles, supplemented by some specified disclosures to meet those objectives. Implementation Guidance, published in a separate booklet, discusses how an insurer might satisfy the requirements. BC200 Although they agreed that insurers should be allowed flexibility in determining the levels of aggregation and amount of disclosure, some respondents suggested that the Board should introduce more specific and standardised disclosure requirements. Others suggested that the draft Implementation Guidance published with ED 5 was at too high a level to ensure consistency and comparability and that its non-mandatory nature might diminish its usefulness. Some were concerned that different levels of aggregation by different insurers could reduce comparability. BC201 Nevertheless, the Board retained ED 5s approach. The Board viewed this as superior to requiring a long list of detailed and descriptive disclosures, because concentrating on the underlying principles:
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(a) makes it easier for insurers to understand the rationale for the requirements, which promotes compliance. (b) avoids hard-wiring into the IFRS disclosures that may become obsolete, and encourages experimentation that will lead to improvements as techniques develop. (c) avoids requiring specific disclosures that may not be needed to meet the underlying objectives in the circumstances of every insurer and could lead to information overload that obscures important information in a mass of detail. (d) gives insurers flexibility to decide on an appropriate level of aggregation that enables users to see the overall picture but without combining information that has different characteristics. BC202 Some respondents expressed the following general concerns about the proposed disclosure requirements in ED 5: (a) The proposed volume of disclosure was excessive and some of it would duplicate extensive material included in some countries in prudential returns. (b) Some of the proposed disclosures would be difficult and costly to prepare and audit, make it difficult to prepare timely financial statements and provide users with little value. (c) The proposals in ED 5 would require excessive disclosure of sensitive pricing information and other confidential proprietary information. (d) Some of the disclosures exceeded those required in other industries, which singled out insurers unfairly. Some felt that the level of disclosure would be particularly burdensome for small insurers, whereas others referred to the difficulty of aggregating information in a meaningful way for large international groups. BC203 The two principles and most of the supporting requirements are applications of existing requirements in IFRSs, or relatively straightforward analogies with existing IFRS requirements (particularly IAS 32). The Boards project on financial risk and other amendments to financial instruments disclosures may lead to amendments to IAS 32 that could require consequential amendments to the disclosures for insurance contracts. Furthermore, that project will consider possible disclosures in various areas that IFRS 4 does not address (eg capital and solvency requirements, market risk, liquidity risk and operational risk).
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BC204 Many respondents asked the Board to clarify the status of the Implementation Guidance. In particular, some felt that the Implementation Guidance appeared to impose detailed and voluminous requirements that contradicted the Boards stated intention in paragraph BC201. In response to requests from respondents, the Board added paragraph IG12 to clarify the status of the implementation guidance on disclosure. BC205 Some suggested that some of the disclosures, particularly those that are qualitative rather than quantitative or convey managements assertions about possible future developments, should be located outside the financial statements in a financial review by management. However, in the Boards view, the disclosure requirements are all essential and should be part of the financial statements. BC206 Some argued that the disclosure requirements could be particularly onerous and less relevant for a subsidiary, especially if the parent guarantees the liabilities or the parent reinsures all the liabilities. However, the Board decided that no exemptions from the disclosure principles were justified. Nevertheless, the high level and flexible approach adopted by the Board enables a subsidiary to disclose the required information in a way that suits its circumstances. BC207 Some respondents expressed concerns that the disclosure proposals in ED 5 might require extensive systems changes in phase I that might not be needed in phase II. The Board expects that both disclosure principles will remain largely unchanged for phase II, although the guidance to support them may need refinement because different information will be available and because insurers will have experience of developing systems to meet the disclosure principles in phase I.
Materiality
BC208 Some respondents expressed concerns that the IFRS (reinforced by the Implementation Guidance) might require disclosure of excessively detailed information that might not be beneficial to users. In response to these concerns, the Board included in the Implementation Guidance a discussion of materiality taken from IAS 1. BC209 Some respondents suggested that some of the qualitative disclosures should not be subject to the normal materiality threshold, which might, in their view, lead to excessive disclosure. They proposed using different terminology, such as significant, to reinforce that message. However, the Board noted that not requiring disclosure of material information
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would be inconsistent with the definition of materiality. Thus, the Board concluded that the disclosure should, in general, rely solely on the normal definition of materiality. BC210 In one place, the IFRS refers to a different notion. Paragraph 37(c) refers to the assumptions that have the greatest effect on the measurement of assets, liabilities, income and expense arising from insurance contracts. Because many assumptions could be relevant, the Board decided to narrow the scope of the disclosure somewhat.
Explanation of recognised amounts

Assumptions
BC211 The first disclosure principle in the IFRS requires disclosure of amounts in an insurers balance sheet and income statement that arise from insurance contracts (paragraph 36 of the IFRS). In support of this principle, paragraph 37(c) and (d) requires disclosure about assumptions and changes in assumptions. The disclosure of assumptions both assists users in testing reported information for sensitivity to changes in those assumptions and enhances their confidence in the transparency and comparability of the information. BC212 Some expressed concerns that information about assumptions and changes in assumptions might be costly to prepare and of limited usefulness. There are many possible assumptions that could be disclosed: excessive aggregation would result in meaningless information, whereas excessive disaggregation could be costly, lead to information overload, and reveal commercially sensitive information. In response to these concerns, the disclosure about the assumptions focuses on the process used to derive them. BC213 Some respondents argued that it is difficult to disclose meaningful information about changes in interdependent assumptions. As a result, an analysis by sources of change often depends on the order in which the analysis is performed. To acknowledge this difficulty, the IFRS does not specify a rigid format or contents for this analysis. This allows insurers to analyse the changes in a way that meets the objective of the disclosure and is appropriate for the risks they face and the systems that they have, or can enhance at a reasonable cost.
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Changes in insurance liabilities

BC214 Paragraph 37(e) of the IFRS requires a reconciliation of changes in insurance liabilities, reinsurance assets and, if any, deferred acquisition costs. IAS 37 requires broadly comparable disclosure of changes in provisions, but the scope of IAS 37 excludes insurance contracts. Disclosure about changes in deferred acquisition costs is important because some existing methods use adjustments to deferred acquisition costs as a means of recognising some effects of remeasuring the future cash flows from an insurance contract (for example, to reflect the result of a liability adequacy test).
Amount, timing and uncertainty of cash flows

BC215 The second disclosure principle in the IFRS requires disclosure of information that helps users understand the amount, timing and uncertainty of future cash flows from insurance contracts (paragraph 38 of the IFRS). The Implementation Guidance supporting this principle builds largely on existing requirements in IFRSs, particularly the disclosures for financial instruments in IAS 32. BC216 Some respondents read the draft Implementation Guidance accompanying ED 5 as implying that the IFRS would require disclosures of estimated cash flows. That was not the Boards intention because insurers cannot be expected to have systems to prepare detailed estimates of cash flows in phase I (beyond what is needed for the liability adequacy test). The Board revised the Implementation Guidance to emphasise that the second disclosure principle requires disclosure about cash flows (ie disclosure that helps users understand their amount, timing and uncertainty), not disclosure of cash flows.
Insurance risk
BC217 For insurance risk (paragraph 39(c)), the disclosures are intended to be consistent with the spirit of the disclosures required by IAS 32. The usefulness of particular disclosures about insurance risk depends on the circumstances of a particular insurer. Therefore, the requirements are written in general terms to allow practice in this area to evolve.
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Sensitivity analysis
BC218 Paragraph 39(c)(i) requires disclosure of a sensitivity analysis. The Board decided not to include specific requirements that may not be appropriate in every case and could impede the development of more useful forms of disclosure or become obsolete. BC219 IAS 32 requires disclosure of a sensitivity analysis only for assumptions that are not supported by observable market prices or rates. However, because the IFRS does not require a specific method of accounting for embedded options and guarantees, including some that are partly dependent on observable market prices or rates, paragraph 39(c)(i) requires a sensitivity analysis for all variables that have a material effect, including variables that are observable market prices or rates.
Claims development
BC220 Paragraph 39(c)(iii) requires disclosure about claims development. The US Securities and Exchange Commission requires property and casualty insurers to provide a table showing the development of provisions for unpaid claims and claim adjustment expenses for the previous ten years, if the provisions exceed 50 per cent of equity. The Board noted that the period of ten years is arbitrary and decided instead to set the period covered by this disclosure by reference to the length of the claims settlement cycle. Therefore, the IFRS requires that the disclosure should go back to the period when the earliest material claim arose for which there is still uncertainty about the amount and timing of the claims payments, but need not go back more than ten years (subject to transitional exemptions in paragraph 44 of the IFRS). Furthermore, the proposal applies to all insurers, not only to property and casualty insurers. However, because an insurer need not disclose this information for claims for which uncertainty about the amount and timing of claims payments is typically resolved within one year, it is unlikely that many life insurers would need to give this disclosure. BC221 In the US, disclosure of claims development is generally presented in managements discussion and analysis, rather than in the financial statements. However, this disclosure is important because it gives users insights into the uncertainty surrounding estimates about future claims, and also indicates whether a particular insurer has tended to overestimate or underestimate ultimate payments. Therefore, the IFRS requires it in the financial statements.
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Probable maximum loss

BC222 Some suggested that an insurerparticularly a general insurershould disclose the probable maximum loss (PML) that it would expect if a reasonably extreme event occurred. For example, an insurer might disclose the loss that it would suffer from a severe earthquake of the kind that would be expected to recur every one hundred years, on average. However, given the lack of a widely agreed definition of PML, the Board concluded that it is not feasible to require disclosure of PML or similar measures.
Exposures to interest rate risk or market risk

BC223 As discussed in paragraphs BC193 and BC194, the Board confirmed that an insurer need not account at fair value for embedded derivatives that meet the definition of an insurance contract, but also create material exposures to interest rate risk or market risk. For many insurers, these exposures can be large. Therefore, paragraph 39(e) of the IFRS specifically requires disclosures about these exposures.
Fair value of insurance liabilities and insurance assets

BC224 ED 5 proposed that an insurer should disclose the fair value of its insurance liabilities and insurance assets. This proposal was intended (a) to give useful information to users of an insurers financial statements and (b) to encourage insurers to begin work on systems that use updated information, to minimise the transition period for phase II. BC225 Some respondents supported the proposed disclosure of fair value, arguing that it is important information for users. Some felt that this would be particularly important given the range of measurement practices in phase I. However, many respondents (including some who supported a fair value disclosure requirement in principle) suggested that the Board should delete this requirement or suspend it until phase II is completed. They offered the following arguments: (a) Requiring such disclosure would be premature before the Board resolves significant issues about fair value measurement and gives adequate guidance on how to determine fair value. The lack of guidance would lead to lack of comparability for users, place unreasonable demands on preparers and pose problems of
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auditability. Furthermore, disclosure cannot rectify that lack of comparability because it is difficult to describe the features of different models clearly and concisely. (b) Disclosure by 2006 (as proposed in ED 5) would be impracticable because insurers would not have time to create and test the necessary systems. (c) Expecting insurers to begin work on an unknown objective would be costly and waste time. Furthermore, in the absence of agreed methods for developing fair value, the systems developed for phase I disclosures of fair value might need changes for phase II. (d) The proposal asked for a mandate for the IASB to interpret its own requirement before explaining what it means. BC226 The Board did not view the proposed requirement to disclose fair value as conditional on the measurement model for phase II. In the Boards view, disclosure of the fair value of insurance liabilities and insurance assets would provide relevant and reliable information for users even if phase II does not result in a fair value model. However, the Board agreed with respondents that requiring disclosure of fair value would not be appropriate at this stage.
SUMMARY OF CHANGES FROM ED 5

BC227 The following is a summary of the main changes from ED 5 to the IFRS. The Board: (a) clarified aspects of the definition of an insurance contract (paragraphs BC36 and BC37). (b) clarified the requirement to unbundle deposit components in some (limited) circumstances (paragraphs BC40-BC54). (c) deleted the sunset clause proposed in ED 5 (paragraphs BC84 and BC85). (d) clarified the need to consider embedded options and guarantees in a liability adequacy test (paragraph BC99) and clarified the level of aggregation for the liability adequacy test (paragraph BC100). (e) replaced the impairment test for reinsurance assets. Instead of referring to IAS 36 (which contained no scope exclusion for reinsurance assets before the Board issued IFRS 4), the test will refer to IAS 39 (paragraphs BC107 and BC108).
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(f)
deleted the proposed ban on recognising a gain at inception of a reinsurance contract, and replaced this with a disclosure requirement (paragraphs BC109-BC114).
(g) clarified the treatment of acquisition costs for contracts that involve the provision of investment management services (paragraphs BC118 and BC119). (h) changed the prohibition on introducing asset-based discount rates into a rebuttable presumption (paragraphs BC134-BC144). (i) clarified aspects of the treatment of discretionary participation features (paragraphs BC154-BC165) and created an explicit new exemption from the requirement to separate, and measure at fair value, some options to surrender a contract with a discretionary participation feature (paragraph 9 of the IFRS). introduced an option for an insurer to change its accounting policies so that it remeasures designated insurance liabilities in each period for changes in interest rates. This election permits a change in accounting policies that is applied to some liabilities, but not to all similar liabilities as IAS 8 would otherwise require (paragraphs BC174-BC177).
(j)
(k) amended IAS 40 to permit two separate elections for investment property when an entity selects the fair value model or the cost model. One election is for investment property backing contracts that pay a return linked directly to the fair value of, or returns from, that investment property. The other election is for all other investment property (paragraph BC178). (l) clarified the applicability of shadow accounting (paragraphs BC181-BC184).
(m) clarified that an embedded derivative is closely related to the host insurance contract if they are so interdependent that an entity cannot measure the embedded derivative separately (ie without considering the host contract) (paragraph BC193). (n) clarified that the Implementation Guidance does not impose new disclosure requirements (paragraph BC204). (o) deleted the proposed requirement to disclose the fair value of insurance contracts from 2006 (paragraphs BC224-BC226). (p) provided an exemption from applying most disclosure requirements for insurance contracts to comparatives that relate to 2004 (paragraphs 42-44 of the IFRS).
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(q) confirmed that unit-denominated payments can be measured at current unit values, for both insurance contracts and investment contracts, avoiding the apparent need to separate an embedded derivative (paragraph AG33(g) of IAS 39, inserted by paragraph C8 of the IFRS).
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Dissenting opinions on IFRS 4

DO1 Professor Barth and Messrs Garnett, Glard, Leisenring, Smith and Yamada dissent from the issue of IFRS 4.
Dissent of Mary E Barth, Robert P Garnett, Gilbert Glard, James J Leisenring and John T Smith
DO2 Messrs Garnett and Glard dissent for the reasons given in paragraphs DO3 and DO4 and Mr Garnett also dissents for the reasons given in paragraphs DO5 and DO6. Professor Barth and Messrs Leisenring and Smith dissent for the reasons given in paragraphs DO3-DO8 and Mr Smith also dissents for the reasons given in paragraphs DO9-DO13.
Temporary exemption from paragraphs 10-12 of IAS 8

DO3 Professor Barth and Messrs Garnett, Glard, Leisenring and Smith dissent because IFRS 4 exempts an entity from applying paragraphs 10-12 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors when accounting for insurance and reinsurance contracts. They believe that all entities should be required to apply these paragraphs. These Board members believe that the requirements in IAS 8 have particular relevance and applicability when an IFRS lacks specificities, as does IFRS 4, which allows the continuation of a variety of measurement bases for insurance and reinsurance contracts. Because of the failure to consider the IASB Framework, continuation of such practices may result in the inappropriate recognition of, or inappropriate failure to recognise, assets, liabilities, equity, income and expense. In these Board members view, if an entity cannot meet the basic requirements of paragraphs 10-12 of IAS 8, it should not be allowed to describe its financial statements as being in accordance with International Financial Reporting Standards. These Board members concerns are heightened by the delay in completing phase II of the Boards project on accounting for insurance contracts. Although phase II is on the Boards active agenda, it is unlikely that the Board will be able to develop an IFRS on insurance contracts in the near term. Accordingly, it is likely that the exemption from IAS 8 will be in place for some time.
DO4
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Future investment margins and shadow accounting

DO5 Professor Barth and Messrs Garnett, Leisenring and Smith dissent for the further reason that they would not permit entities to change their accounting policies for insurance and reinsurance contracts to policies that include using future investment margins in the measurement of insurance liabilities. They agree with the view expressed in paragraph BC134 that cash flows from an asset are irrelevant for the measurement of a liability (unless those cash flows affect the cash flows arising from the liability or the credit characteristics of the liability). Therefore, they believe that changing to an accounting policy for insurance contracts that uses future investment margins to measure liabilities arising from insurance contracts reduces the relevance and reliability of an insurers financial statements. They do not believe that other aspects of an accounting model for insurance contracts can outweigh this reduction. These four Board members also would not permit entities to change their accounting policies for insurance and reinsurance contracts to policies that include using what is called shadow accounting. They do not believe that the changes in the carrying amount of insurance liabilities (including related deferred acquisition costs and intangible assets) under shadow accounting should be recognised directly in equity. That these changes in the measurement of the liability are calculated on the basis of changes in the measurement of assets is irrelevant. These Board members believe that these changes in insurance liabilities result in expenses that under the IASB Framework should be recognised in profit or loss.
DO6
Financial instruments with a discretionary participation feature

DO7 Professor Barth and Messrs Leisenring and Smith would not permit entities to account for a financial instrument with a discretionary participation feature on a basis that differs from that required by IAS 32 Financial Instruments: Disclosure and Presentation and IAS 39 Financial Instruments: Recognition and Measurement. Those Standards require entities to separate the components of a compound financial instrument, recognise the liability component initially at fair value, and attribute any residual to the equity component. These three Board members believe that the difficulty in determining whether a discretionary participation feature is a liability or equity does not preclude applying the measurement requirements in IAS 39 to the liability and equity components once the
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entity makes that determination. These three Board members believe that an entity would misstate interest expense if the financial liability component is not initially measured at its fair value. DO8 These three Board members would require entities to ensure in all cases that the liability recognised for financial instruments with a discretionary participation feature is no less than the amount that would result from applying IAS 39 to the guaranteed element. Paragraph 35 of IFRS 4 requires this if an entity classifies none or some of the feature as a liability, but not if it classifies all of the feature as a liability.
Financial instruments
DO9 Mr Smith also dissents from IFRS 4 because he believes it defines insurance contracts too broadly and makes unnecessary exceptions to the scope of IAS 32 and IAS 39. In his view, this permits the structuring of contractual provisions to avoid the requirements of those Standards, diminishing their effectiveness and adding considerable complexity in interpreting and applying them and IFRS 4. He believes that many of the exceptions, based on the desire to avoid systems changes, are unnecessary because they generally are unrelated to the second phase of the project on insurance contracts, and they create a disincentive to enhance systems before the second phase of that project is completed. Mr Smith believes that IAS 32 and IAS 39 already contain the appropriate solutions when measurements cannot be made reliably and those solutions make systems limitations transparent. Paragraph 10 of IFRS 4 requires an insurer to unbundle a deposit component of an insurance contract if the insurer can measure the deposit component separately and the insurers accounting policies do not otherwise require it to recognise all rights and obligations arising from the deposit component. Mr Smith notes that the deposit component consists entirely of financial liabilities or financial assets. Therefore, he believes that the deposit component of all insurance contracts should be unbundled. Mr Smith notes that IAS 32 already requires the liability component of a compound financial instrument to be separated at its fair value with any residual accounted for as equity. He believes this approach could be applied by analogy when an insurance contract contains a financial liability and would represent a superior solution. IFRS 4 amends IAS 39 by stating that an embedded derivative and the host insurance contract are closely related if they are so interdependent that the entity cannot measure the embedded derivative separately. This creates an exemption from the requirement in IAS 39 to account for such embedded derivatives at fair value. Mr Smith disagrees with that change.
DO10
DO11
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In particular, if a contract permits a policyholder to obtain a derivative-based cash settlement in lieu of maintaining insurance, Mr Smith believes that the derivative-based cash settlement alternative is a financial liability and should be measured at fair value. DO12 For the contracts discussed in the previous paragraph, Mr Smith believes that IAS 39 already provides a superior solution that will not promote structuring to take advantage of an exception to IAS 39. It requires the entire contract to be measured at fair value when an embedded derivative cannot be reliably separated from the host contract. However, Mr Smith would amend IAS 39 to require measurement at cost if a contract cannot be measured reliably at fair value in its entirety and contains a significant insurance component as well as an embedded derivative. This amendment would be consistent with similar requirements in IAS 39 for unquoted equity instruments. To make systems limitations more transparent, Mr Smith would add the disclosure required by IAS 32, including the fact that fair value cannot be measured reliably, a description of the insurance contracts in question, their carrying amounts, an explanation of why fair value cannot be measured reliably and, if possible, the range of estimates within which fair value is likely to fall. Mr Smith would exclude from the definition of an insurance contract those contracts that are regarded as transferring significant insurance risk at inception only because they include a pricing option permitting the holder to purchase insurance at a specified price at a later date. He would also exclude from the definition those contracts in which the insurance component has expired. He believes that any remaining obligation is a financial instrument that should be accounted for under IAS 39.
DO13
Dissent of Tatsumi Yamada

DO14 Mr Yamada dissents from the issue of IFRS 4 because he believes that it does not resolve appropriately the mismatch in measurement base between financial assets of insurers and their insurance liabilities. Specifically: (a) he disagrees with the inclusion of an option to introduce a current discount rate for designated insurance liabilities. (b) he believes that the Board should have provided a practicable means to reduce the effect of the accounting mismatch using methods based partly on some existing practices that involve broader, but constrained, use of amortised cost.
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Option to introduce a current discount rate

DO15 Mr Yamada disagrees with paragraph 24 of the IFRS, which creates an option to introduce a current market-based discount rate for designated insurance liabilities. He has sympathy for the view expressed in paragraph BC175 that introducing a current market-based discount rate for insurance liabilities rather than a historical discount rate would improve the relevance and reliability of an insurers financial statements. However, as explained in paragraph BC126, the Board will not address discount rates and the basis for risk adjustments until phase II. Therefore, Mr Yamada believes that it is not appropriate to deal with measurement of insurance liabilities in phase I of this project. In addition, Mr Yamada believes that there should be a stringent test to assess whether changes in the carrying amount of the designated insurance liabilities mitigate the changes in carrying amount of financial assets. Without such a test, management will have a free choice to decide the extent to which it introduces remeasurement of insurance liabilities. Therefore, he does not agree with the Boards conclusion in paragraph BC176 that the increase in relevance and reliability from introducing a current discount rate could outweigh the disadvantages of permitting accounting policies that are not applied consistently to all similar liabilities. Furthermore, the option introduced by paragraph 24 is not an effective way to reduce the accounting mismatch, in Mr Yamadas view. He agrees with the Boards analysis that many insurers may not have systems to adjust liabilities for changes in interest rates and may not wish to develop such systems, even for designated liabilities as opposed to all liabilities, as explained in paragraph BC177(d)(i).
DO16
DO17
Assets held to back insurance liabilities

DO18 As stated in paragraph BC171, many of the respondents to ED 5 urged the Board to explore ways of reducing the accounting mismatch. Mr Yamada notes that IFRS 4 provides some limited solutions for the accounting mismatch by clarifying that shadow accounting can be used and amending IAS 40 to permit two separate elections when an entity selects the fair value model or the cost model for investment property. IFRS 4 also provides an option to introduce a current market-based discount rate for designated insurance liabilities but, for reasons given in paragraphs DO15-DO17, Mr Yamada does not support that option.
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DO19
Mr Yamada believes that it would have been appropriate to provide a more broadly applicable way of mitigating the effect of the accounting mismatch. Because phase I is only a stepping stone to phase II, Mr Yamada is of the view that the only practicable solution in the short term is one based on the existing practices of insurers. He believes that if remeasurement of insurance liabilities by a current market-based discount rate is allowed as means of resolving the mismatch, a new category of assets carried at amortised cost such as the Japanese debt securities earmarked for policy reserve (DSR) should also have been allowed in phase I. Although Mr Yamada acknowledges that the DSR approach would not lead to more relevant and reliable measurements, he notes that insurers have several years experience of using this approach, which was created in 2000 when Japan introduced an accounting standard for financial instruments that is similar to IASs 32 and 39. He believes that no perfect solution is available in phase I and together with the disclosure of fair value information required by IAS 32, the DSR approach would provide a reasonable solution for phase I. Therefore he does not agree with the Boards conclusion in paragraph BC178 that amending the existing measurement requirements in IAS 39 for financial assets would have reduced the relevance and reliability of financial statements to an unacceptable extent. Indeed, Mr Yamada believes the exemption in IFRS 4 from paragraphs 10-12 of IAS 8 could impair the relevance and reliability of financial statements more than introducing the DSR approach would have done.
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IFRS 4 Basis For Conclusions

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IFRS 4 Basis For Conclusions

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March 2004

Basis for Conclusions

BASIS FOR CONCLUSIONS ON INTERNATIONAL FINANCIAL REPORTING STANDARD

IFRS 4 Insurance Contracts

International Accounting Standards Board

Basis for Conclusions on

IFRS 4 Insurance Contracts

IFRS 4 INSURANCE CONTRACTS