“Insurance industry braces for changes in financial reporting” by Lucy Lim-Chan and Bernadette R. Santiago (August 9, 2010)

SUITS THE C-SUITE By Lucy Lim-Chan and Bernalette R. Santiago
Business World (08/09/2010)

Financial statements of insurance companies have been described traditionally as a “black box” because they do not seem to provide relevant information about an insurer’s financial position and performance.

Under Phase 1 of International Financial Reporting Standard (IFRS) 4 implemented in 2005, accounting for insurance contracts remained driven primarily by regulatory requirements, and required merely enhanced disclosures.

Last July 30, the International Accounting Standards Board (IASB) released the exposure draft (ED) on Phase 2 of IFRS 4 Insurance Contracts. The ED remains open to comments until Nov. 30, and the final standard is expected to be issued by July 30, 2011. Since the ED is the result of the IASB-US Financial Accounting Standard Board convergence project, the ED has the benefit of the US standard-setter’s views.

Once finalized into a standard, the ED will help create a level playing field for the global insurance industry. It will provide financial statement users and preparers with consistent measurement and presentation models for greater comparability and transparency.

However, insurance companies must be aware that the journey will be a difficult one, fraught with challenges up to the final implementation stages. As currently drafted, the recognition, measurement and presentation provisions of the ED will definitely change the way insurance companies account for the insurance contracts that they issue, the reinsurance contracts that they hold, and how the related assets, liabilities, revenue and expenses are presented in their financial statements.

The measurement of the insurance contract liabilities lies at the heart of the ED. Consistent with the overall direction of the IFRS, the ED boldly prescribes a fair value approach in measuring the insurance contract liabilities using the present value of the fulfilment cash flows.

The ED defines the following building blocks:

• an explicit, unbiased and probability-weighted estimate (i.e., expected value) of the future cash flows that will arise as the insurer fulfils the insurance contract;

• a discount rate to adjust the cash flows for the time value of money;

• an explicit risk adjustment to capture the effects of uncertainty associated with the cash flows (using either of the three permitted techniques); and

• a residual margin that eliminates any gain at the inception of the contract (while a loss is immediately charged to the income statement).

The cash flows and the risk adjustment are remeasured at each reporting period and any movements recorded in profit or loss: the residual margin is not remeasured but released to profit or loss over the coverage period with interest accreted on its carrying amount.

Accountants familiar with IFRS will find this conceptual approach seemingly similar to the measurement of provisions under IAS 37.

For local insurance companies, however, this measurement approach is totally different from how insurance liabilities are currently computed. Specifically, the legal policy reserves are computed based on the guidelines from the Insurance Commission, and the assumptions are generally “locked” at inception dates (unless there are inadequacies that have to be covered). This is one area where the Philippine insurance industry will be faced with significant implementation challenges.

The calculation of the fulfilment cash flows requires the use of numerous inputs and variables, most of which are not observable in the market and will require the use of internal data for estimation. Many insurance companies may not have the capability today to capture all the information required by the ED. Insurers will have to change or modify their existing information systems, policies and processes to gather and maintain this information, perform probability weighted scenarios, and introduce more sophisticated actuarial models.

Since the insurance contract liabilities are computed using inputs and assumptions that are heavily dependent on estimates and judgments, changes in these variables may create volatility that will impact on an insurer’s results of operations.

For short duration insurance contracts issued by nonlife insurance companies, the ED allows the use of a simplified measurement model for pre-claims liability largely similar to existing practice, but with the additional requirement to accrete interest on the pre-claims liability.

However, the simplified measurement model is not as simple as it sounds, because adopting it will require the insurer to perform an onerous contract test which basically uses the present value of the fulfilment cash flows.

Another paradigm shift for the local insurance industry is the financial statement presentation.

While the provisions for presenting the statement of financial position are reasonably understandable, the changes introduced in the presentation of the statement of comprehensive income will be a controversial area. Except for contracts covered under the simplified measurement model, premiums will no longer be recognized as revenue in the statement of comprehensive income but will be treated similar to deposit receipts. Meanwhile, claims and claims handling expenses, incremental acquisition costs and other expenses included in the measurement of the insurance contract will be treated as repayment of deposits.

What then would comprise a life insurer’s statement of comprehensive income?

This will be the underwriting margin consisting of the change in the risk adjustment and the release of the residual margin, the difference between the expected and actual cash flows, changes in estimates, and interest on insurance liabilities.

Clearly, this is a different way of measuring an insurer’s financial performance which has been traditionally ranked by premiums.

The ED also proposes significant changes in other areas, such as accounting for unit-linked products, reinsurance contracts and acquisition costs, measurement of significant insurance risk and definition of contract boundaries.

Obviously, the changes introduced by the ED will have far-reaching implications on an insurer’s product design and pricing, operations, systems and processes, profit emergence, performance measure, financial reporting and people complement.

While the new standard is not expected to become effective until 2013 or later, insurance companies are advised to brace for the changes that may transform the industry.

(As of publication, Lucy Lim-Chan and Bernalette R. Santiago are Assurance Partners of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.