Background

IFRS 4 is the first guidance from the IASB on accounting for insurance contracts – but not the last. A Second Phase of the IASB's Insurance Project is under way. The Board issued IFRS 4 because it saw an urgent need for improved disclosures for insurance contracts, and modest improvements to recognition and measurement practices, in time for the adoption of IFRS by listed companies throughout Europe and elsewhere in 2005. The improvements to recognition and measurement are ones that will not likely have to be reversed when the IASB completes the second phase of the project.

Summary of IFRS 4

Scope. IFRS 4 applies to virtually all insurance contracts (including reinsurance contracts) that an entity issues and to reinsurance contracts that it holds. It does not apply to other assets and liabilities of an insurer, such as financial assets and financial liabilities within the scope of IAS 39 Financial Instruments: Recognition and Measurement. Furthermore, it does not address accounting by policyholders.

Definition of insurance contract. An insurance contract is a "contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder."

Accounting policies. The IFRS exempts an insurer temporarily (until completion of Phase II of the Insurance Project) from some requirements of other IFRSs, including the requirement to consider the IASB's Framework in selecting accounting policies for insurance contracts. However, the IFRS:

• Prohibits provisions for possible claims under contracts that are not in existence at the reporting date (such as catastrophe and equalisation provisions).
• Requires a test for the adequacy of recognised insurance liabilities and an impairment test for reinsurance assets.
• Requires an insurer to keep insurance liabilities in its balance sheet until they are discharged or cancelled, or expire, and prohibits offsetting insurance liabilities against related reinsurance assets.

Changes in accounting policies. IFRS 4 permits an insurer to change its accounting policies for insurance contracts only if, as a result, its financial statements present information that is more relevant and no less reliable, or more reliable and no less relevant. In particular, an insurer cannot introduce any of the following practices, although it may continue using accounting policies that involve them:

• Measuring insurance liabilities on an undiscounted basis.
• Measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current market-based fees for similar services.
• Using non-uniform accounting policies for the insurance liabilities of subsidiaries.

Remeasuring insurance liabilities. The IFRS permits the introduction of an accounting policy that involves remeasuring designated insurance liabilities consistently in each period to reflect current market interest rates (and, if the insurer so elects, other current estimates and assumptions). Without this permission, an insurer would have been required to apply the change in accounting policies consistently to all similar liabilities.

Prudence. An insurer need not change its accounting policies for insurance contracts to eliminate excessive prudence. However, if an insurer already measures its insurance contracts with sufficient prudence, it should not introduce additional prudence.

Future investment margins. There is a rebuttable presumption that an insurer's financial statements will become less relevant and reliable if it introduces an accounting policy that reflects future investment margins in the measurement of insurance contracts.

Asset classifications. When an insurer changes its accounting policies for insurance liabilities, it may reclassify some or all financial assets as 'at fair value through profit or loss'.

Other issues. The IFRS:

• Clarifies that an insurer need not account for an embedded derivative separately at fair value if the embedded derivative meets the definition of an insurance contract.
• Requires an insurer to unbundle (that is, to account separately for) deposit components of some insurance contracts, to avoid the omission of assets and liabilities from its balance sheet.
• Clarifies the applicability of the practice sometimes known as 'shadow accounting'.
• Permits an expanded presentation for insurance contracts acquired in a business combination or portfolio transfer.
• Addresses limited aspects of discretionary participation features contained in insurance contracts or financial instruments.

Disclosures. The IFRS requires disclosure of:

• Information that helps users understand the amounts in the insurer's financial statements that arise from insurance contracts:

Ø       Accounting policies for insurance contracts and related assets, liabilities, income, and expense.

Ø       The recognised assets, liabilities, income, expense, and cash flows arising from insurance contracts.

Ø       If the insurer is a cedant, certain additional disclosures are required.

Ø       Information about the assumptions that have the greatest effect on the measurement of assets, liabilities, income, and expense including, if practicable, quantified disclosure of those assumptions.

Ø       The effect of changes in assumptions.

1. Reconciliations of changes in insurance liabilities, reinsurance assets, and, if any, related deferred acquisition costs.
• Information that helps users understand the amount, timing and uncertainty of future cash flows from insurance contracts:
  1. Risk management objectives and policies.
  2. Those terms and conditions of insurance contracts that have a material effect on the amount, timing, and uncertainty of the insurer's future cash flows.
  3. Information about insurance risk (both before and after risk mitigation by reinsurance), including information about:
     • The sensitivity of profit or loss and equity to changes in variables that have a material effect on them.
     • Concentrations of insurance risk.
     • Actual claims compared with previous estimates.
  4. The information about interest rate risk and credit risk that IAS 32 would require if the insurance contracts were within the scope of IAS 32.
  5. Information about exposures to interest rate risk or market risk under embedded derivatives contained in a host insurance contract if the insurer is not required to, and does not, measure the embedded derivatives at fair value.

Effective date. Entities should apply the IFRS for annual periods beginning on or after 1 January 2005, but earlier application is encouraged. An insurer need not apply some aspects of the IFRS to comparative information that relates to annual periods beginning before 1 January 2005.

August 2005 Amendment to IAS 39 and IFRS 4 – Financial Guarantee Contracts

On 18 August 2005, the IASB has amended the scope of IAS 39 to include financial guarantee contracts issued. However, if an issuer of financial guarantee contracts has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply either IAS 39 or IFRS 4 Insurance Contracts to such financial guarantee contracts.

A financial guarantee contract is a contract that 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 IAS 39 as amended, financial guarantee contracts are initially recognised at fair value and are subsequently measured at the greater of (a) the amount determined in accordance with IAS 37 and (b) the amount initially recognised less, where appropriate, cumulative amortisation recognised in accordance with IAS 18. The issuer may make that election contract by contract, but the election for each contract is irrevocable.

The amendments to IAS 39 and IFRS 4 are effective for annual periods beginning on or after 1 January 2006, with earlier application encouraged.