Grappling with the IASB’s proposed new rules

While the International Accounting Standards Board (IASB)’s new universal accounting regime for insurance contracts may have bigger implications for life insurers, there will still be fundamental changes to the way non-life insurers must report their numbers.

It is important to note the IASB’s volte-face on fair-value accounting. The cornerstone of the board’s previous attempts to reform the regime was the notion of representing insurance liabilities at fair value – in other words, a generally accepted market price.

But the challenges of measuring insurance liabilities in such a way is one of the main reasons why, when the rest of the financial world shifted to International Financial Reporting Standards in 2005, including the asset side of insurers’ balance sheets, accounting for insurance liabilities remained largely unchanged.

Building blocks

Accordingly, the new regime has abandoned the fair-value approach. Instead of using a market price to determine the value of insurance liabilities, it effectively uses the individual company’s assumptions about the risk inherent in those liabilities as a yardstick.

Instead of reporting premiums minus claims in the first lines of the income statement, companies will instead report four ‘building blocks’. These comprise:

• the current best estimate of future cashflows from a contract (expected premiums and claims);
• the rate at which these future flows are discounted to represent their present value (in other words, the current interest rate);
• the risk margin the company sets aside above the best estimate;
• and a ‘residual margin’ (the profit margin of the contract once all those items are considered).

In companies’ interest

One of the key differences about this approach is the discounting of future cashflows to represent their present value – the only element of the new regime that uses an external, market-consistent measure (the interest rate) rather than a company-specific one.

In general, current insurance liability accounting does not take account of the time value of money – the fact that a sum received immediately is worth more than the same sum received in a year’s time because the company can receive interest by investing it.

To calculate the present value of a cashflow expected in one year, a company has to subtract from this the amount of interest it could have earned in that year from the sum.

Taking a short cut

The second key difference is the explicit separation of the risk margin from the best estimate, which will make it clear to the outside world exactly how the company is valuing the liability and the margins it is setting aside to cover any uncertainties.

Previously, the expected claims liability was a single amount, which meant it wasn’t possible to see how well or poorly a company had reserved for a contract.

Insurers that write only short-tail contracts – those that last 12 months or less – will have it slightly easier. Instead of reporting the four ‘building blocks’ they will be able to take the short-cut of reporting using the ‘unearned premium’ method – much as they do now.

But they will need to use the building blocks once they receive a claim on a contract, and they will still have to discount outstanding claims using the current interest rate.

Another key change, which will be a benefit to insurers that write business in foreign currencies, is the representation of unearned premiums as a monetary item.

Under current accounting, unearned premium is recorded as a non-monetary item, which means that foreign currency amounts are accounted for at a fixed exchange rate at the inception date of the contract. Any investments supporting these premiums, however, are recorded at the current exchange rate, resulting in a mismatch.

Practising for Solvency II

While the insurance industry has broadly welcomed the IASB’s latest proposals, there are still details that need to be hammered out before the new rules come into force. It is not clear, for example, how companies that write both long- and short-duration policies should present their accounts.

Also, under the current proposals, insurers writing short-duration contracts have no option but to use the unearned premium accounting method, rather than the new building blocks.

While the building blocks approach is arguably more work and a bigger change, many may want to move to it because the European Commission’s Solvency II regime requires them to use a similar building blocks approach.

“I think a number of insurers may say they want that short-cut approach to be optional not mandatory,” says PricewaterhouseCoopers partner Gail Tucker.