FASB Issues Exposure Draft on Insurance Contracts
The FASB released for public comment on June 27, 2013, a proposed ASU¹ as part of the FASB-IASB joint project to attempt to create a consistent approach for measuring insurance contracts. The IASB issued its second exposure draft (ED)² on this topic on June 20, 2013. Comments on both proposals are due by October 25, 2013.
While the boards have made progress in bridging their differing views over the past two years of deliberations, the proposals are not fully converged. Unlike the IASB’s ED, which asks questions on only seven topics,³ the proposed ASU seeks constituents’ views on all aspects of the proposed accounting model for insurance contracts.
Editor’s Note: Although it seems likely that the new insurance contract standards will not be fully converged, the boards will continue to jointly redeliberate the project and are dedicated to achieving convergence whenever possible.
Below is an excerpt from Deloitte’s Heads Up newsletter, discussing key elements of the FASB’s proposed ASU. See the full newsletter for a discussion of the following topics: Unit of Account, Unbundling, Reinsurance, Insurance Revenue, Presentation and Disclosure, and Transition. The newsletter also contains several appendices, including Appendix A, which compares the FASB’s proposal with current U.S. GAAP, and Appendix B, which compares the proposal with the IASB’s ED. For more information about the IASB’s ED, see Deloitte’s June 21, 2013, IFRS in Focus.
The proposed ASU would apply to all entities that issue or reinsure insurance contracts but not to policyholders (other than holders of reinsurance contracts). Unlike existing U.S. GAAP, the proposed insurance accounting model is contract-driven; it is not limited to traditional insurance companies or captive insurance subsidiaries. The proposal defines an insurance contract as a “contract under which one party (the issuing entity) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or its designated beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder.”
Certain types of contracts are outside the scope of the the proposed ASU, including:
- “Product warranties issued by a manufacturer, dealer, or retailer.”
- An “[e]mployer’s assets and liabilities under employee benefit plans . . . and retirement benefit obligations reported by defined benefit retirement plans.”
- “Employer-provided insurance.”
- “Contractual rights or contractual obligations that are contingent on the future use of, or right to use, a nonfinancial item.”
- “Residual value guarantees provided by a manufacturer, dealer, or retailer, as well as a lessee‘s residual value guarantee embedded in a finance lease.”
- Certain “fixed-fee service contracts.”⁴
- Certain guarantees.
Editor’s Note: Entities may have to exercise significant judgment to determine whether certain fixed-fee or financial guarantee arrangements are within the scope of the proposed ASU. Contracts that may qualify for the fixed-fee scope exception include (1) capitation and other fixed-fee medical service arrangements in which the customer is not certain to receive a service from the provider unless certain medical events occur, (2) typical fixed-fee prepaid maintenance and repair contracts, and (3) traditional roadside assistance programs.
Overview of the Measurement Models
The proposed ASU identifies two distinct models: (1) the premium allocation approach (PAA) and (2) the building block approach (BBA). The PAA is more akin to the proposed revenue recognition model, while the BBA focuses on liability measurement and overall fulfillment cash flows. The sections below describe the two models in more detail and discuss how an entity would determine which model to apply to a portfolio of insurance contracts.
Editor’s Note: The introduction of two models constitutes a key difference between the FASB’s proposed ASU and the IASB’s ED. Unlike the FASB, the IASB decided that the PAA is not a distinct model but a simplification of the BBA and can only be applied to contracts in which the measurements under the PAA are a proxy for those under the BBA.
An insurance contract is recognized initially at the beginning of the coverage period⁵; the contract is derecognized when it is discharged, is canceled, or expires.
Premium Allocation Approach
Under the PAA, the preclaim liability for remaining coverage is measured initially as the present value of the premiums received and receivable under the contract, net of acquisition costs (AC) (an approach similar to the unearned premium reserve (UPR) concept under current U.S. GAAP). Subsequently, the liability for remaining coverage is reduced in a manner consistent with the coverage provided (i.e., according to the passage of time or the expected timing of incurred claims and benefits). As insured events occur, an entity will record a liability for incurred claims, measured as the present value of expected fulfillment cash flows.
Editor’s Note: At initial recognition, the overall liability recorded under the PAA looks similar to that recorded under the short-duration contract accounting model in current U.S. GAAP. Differences arise during the coverage period and at the end of coverage because the liabilities for (1) claims and (2) claims incurred but not reported (IBNR) recorded on the basis of management’s best estimate under existing U.S. GAAP are not expected to equal the liability for incurred claims, which, under the proposed ASU, is recorded on the basis of discounted unbiased estimates of future cash flows of incurred claims.
Onerous Contract Test
The proposed ASU defines an onerous contract as “[a] contract in which the present value of the future costs of fulfilling the unexpired portion of coverage (that is, the liability for remaining coverage) and the expected qualifying acquisition costs are expected to exceed the carrying amount of the liability related to the unexpired portion of coverage.”
Onerous contracts should be measured on a basis consistent with the measurement of the liability for incurred claims (i.e., if the liability is not discounted for the reasons discussed below, the entity should perform the onerous contract analysis on an undiscounted basis). In addition, the proposed ASU specifies that the unit of account for performing the onerous test should be the portfolio.
Discounting Cash Flows
Under the PAA, discounting and interest accretion are generally required for both the liability for remaining coverage (expressed above as UPR) and the liability for incurred claims unless the contracts qualify for one of the practical expedients provided under the proposed ASU. Specifically, entities need not apply discounting or interest accretion to the liability for remaining coverage if they expect, at contract inception, that “the time period between when the policyholder pays all or substantially all of the premium” and the satisfaction of the entity’s obligation to provide insurance coverage will be one year or less.
The liability for incurred claims under the PAA is measured as the present value of expected fulfillment cash flows without applying an explicit risk adjustment. This is a key difference from the IASB’s model. ASC 834-10-35-33 (as proposed) provides a practical expedient under which an entity would not be required to discount the expected cash flows when (1) the effects of discounting are immaterial or (2) the incurred claims are expected to be paid within one year of the insured event. See Appendix D in the full newsletter for additional information (including graphs) about the differences between the BBA and PAA as well as a comparison between the FASB’s and IASB’s measurement models.
Editor’s Note: The FASB expects a large number of insurance contracts accounted for under the PAA to qualify for the 12-month practical expedient on discounting.
Building Block Approach
The BBA is a proposed insurance liability measurement model based on a fulfillment objective, not fair value, and is designed to portray management’s current assessment of the amount and timing of future cash flows necessary to fulfill its obligations under the contract by incorporating three basic building blocks: (1) unbiased future cash flows, (2) the time value of money (i.e., discount), and (3) a margin.
Unbiased Future Cash Flows
An entity would make an explicit, unbiased, and probability-weighted estimate of future cash flows that takes into account a full range of possible outcomes through the contract boundary (i.e., inflows and outflows that are expected to occur, such as premiums and claims), but not necessarily every possible scenario. The contract boundary for an individual contract would extend until the point at which the entity can unilaterally terminate or re-underwrite the contract (i.e., reassess the risk of the particular policyholder and reprice the contract accordingly to fully reflect the risk). Similarly, as indicated in ASC 834-10-25-14 (as proposed), for a portfolio of contracts the contract boundary would be the date as of which the entity can (1) reassess the risks in the portfolio and “set a price or level of benefits that fully reflects the risk of that portfolio” and (2) determine that the pricing of the premiums for coverage until the date as of which the portfolio risks are reassessed does not take risks related to future periods into account.
Editor’s Note: In determining its probability-weighted estimates, an entity would be required to develop multiple scenarios and assign each a specific probability. Further, for some products, the unbiased cash flow estimates would not take into account provisions for adverse deviation that are included in the measurement under current U.S. GAAP. While not required by the proposed ASU, stochastic modeling may be the most reliable approach to calculating the expected value of many life insurance contracts. This method is not generally common in current insurance accounting models and may therefore require model and system adjustments.
Current Discount Rate
The proposed ASU requires an entity to reflect the time value of money by discounting the expected cash flows by using a current discount rate that reflects the characteristics of the insurance liability (i.e., its currency, duration, and liquidity). The discount rate should be updated for each reporting period. Although the proposal does not prescribe a method for computing the appropriate discount rate, it describes two broad approaches that an entity could use:
- A “top-down” approach under which the rate of a reference portfolio of assets (that the entity is not required to physically hold) is adjusted to reflect the characteristics of the insurance liability. Adjustments may be required because of (1) differences between the timing of the cash flows of the liability and that of the assets backing the liabilities (e.g., duration) and (2) risks associated with the assets but not with the liability (e.g., credit risk).
- A “bottom-up” approach under which the discount rate is derived by adjusting a risk-free rate to incorporate liability characteristics.
Editor’s Note: Through their outreach efforts, the boards became aware of constituents’ concerns about income statement volatility that may arise after initial recognition of an insurance contract in connection with use of a current discount rate that is updated in each reporting period. To respond to these concerns, the FASB is proposing that entities be required to recognize all subsequent changes to fulfillment cash flows directly attributable to changes in the discount rate in other comprehensive income (OCI) except for certain contracts that are contractually linked to underlying assets. See Appendix E in the full newsletter for additional information about the mechanics of this “OCI solution.”
The final element of the BBA is margin (the embedded profit in the insurance contract). At the inception of a contract, after discounting the unbiased estimate of future cash flows at a current discount rate, an entity will compute a margin equal to the amount by which the expected cash inflows exceed expected cash outflows, thus avoiding recognition of any day 1 gains. An entity would recognize the margin in net income over the coverage and settlement periods as it is released from risk.
Editor’s Note: During its deliberations, the FASB expressed its belief that one margin (as defined) implicitly reflects both elements of the risk adjustment and contractual service margin proposed in the IASB’s ED (i.e., the two-margin approach). This topic has been a key point of debate during the boards’ joint deliberations of the models.
The proposed ASU does not prescribe a method for amortizing the margin; it only specifies that the margin should be recognized as revenue “as the entity satisfies its performance obligation to stand ready to compensate the policyholder on occurrence of a specified event that adversely affects the policyholder.” Further, “an entity satisfies its performance obligation as it is released from exposure to risk.” Accordingly, there is no “one size fits all” method for amortizing the margin; the method an entity uses will most likely vary by contract type.
See Appendices A, B, and D in the full newsletter for additional details on each of the components of the BBA as well as a comparison of the model with current U.S. GAAP and with the IASB’s ED.
Determining Which Measurement Model to Apply
In determining whether a contract should be accounted for under the BBA or the PAA, an entity would first determine whether the coverage period of the insurance contract is one year or less. If so, the entity would use the PAA. If not, the entity would then consider at contract inception whether, during the period before a claim is incurred, there will be significant variability in the expected value of the net cash flows required to fulfill the contract. If significant variability is not expected, the entity would apply the PAA; otherwise, it would apply the BBA.
Under ASC 834-10-55-52 (as proposed), indicators of whether significant cash flow variability is present in the preclaim period include:
- The presence of minimum guarantees or options.
- The likelihood that circumstances unforeseen at contract inception could cause the expected cash flows to change significantly.
- The entity’s expectations at contract inception regarding whether, during the coverage period, it will significantly change premium pricing for future contracts.
- The length of the coverage periods of the contract.
Editor’s Note: Individual contract features affect an entity’s assessment of whether to apply the BBA or PAA. While some contract classifications may appear obvious (e.g., a six-month auto policy), classification of other insurance products may be more subjective, such as (1) five-year term life insurance, (2) surety bonds, and (3) certain types of medical malpractice insurance. ASC 834-10-55-53 (as proposed) contains a tabular analysis of the appropriate model to apply to various types of contracts.
—Produced by Bryan Benjamin, Mark Bolton, Joe DiLeo, Allison Gomes, and Rick Sojkowski, Deloitte & Touche LLP
For more details, read Heads Up Volume 20, Issue 25, FASB Issues Exposure Draft on Insurance Contracts.
1. FASB Proposed Accounting Standards Update, Insurance Contracts.
2. IASB Exposure Draft, Insurance Contracts.
3. Because this is the second ED that the IASB has issued for this project, it did not feel the need to seek constituents’ views on aspects of the proposed model that it had previously requested feedback on.
4. ASC 834-10-15-5 (as proposed) states that contracts outside the proposal’s scope would include certain fixed-fee service contracts whose primary purpose is the provision of services, provided that (1) the “price of the contract is not based on an assessment of the risk associated with an individual customer unless that assessment is limited to consideration of the customer’s credit risk,” (2) the “contract compensates customers by providing a service rather than by making a cash payment to the customer or to a third-party provider,” and (3) the “insurance risk transferred by the contract arises primarily from uncertainty about the utilization of the policyholder‘s use of services (that is, frequency risk) relative to the overall risk transferred in the contract.”
5. An exception to this general requirement is that if an entity determines before the coverage period that (1) a portfolio of contracts is onerous and (2) it is still obligated to provide coverage to policyholders, it must recognize the liability for that onerous contract in the precoverage period. See ASC 834-10-25-12 (as proposed).