This document is provided as the basis for discussion with the objective to develop an ACLI position on the subject matter. These notes are based on staff’s analysis of tentative views of the IASB and FASB, reference to various resource documents, and prior ACLI discussions and position statements expressed in letters to accounting standard setters on the topic.

INFORMATION FOR DEPUTIES SUBGROUP

Date: December 28, 2010

Project: Insurance Contracts

Topic: Cost Option for the Measurement of Certain Insurance Contracts______________________________________________________________________________

Introduction

The IASB and FASB are in the process of developing an accounting standard for insurance contracts. The proposed measurement attribute is a “current fulfillment” model where the inputs into the measurement of the insurance liability are unlocked at each reporting period. The current fulfillment model would be the only measurement attribute for insurance contracts, unlike IFRS 9, Financial Instruments, which is a mixed attribute standard with financial instruments measured at fair value or amortized cost.

Issues

In developing the ACLI response to the IASB Exposure Draft, Insurance Contracts (ED), and the FASB Discussion Paper on the same topic, we stated:

While we have no objection to the current fulfillment measurement approach, we are concerned that the insurance accounting standard will not align with the guidance in IFRS 9, Financial Instruments, where financial instruments may be measured at fair value or amortized cost. Limiting the measurement of insurance contracts to a current value measurement could put insurers at a disadvantage with other financial institutions for financial products. The ACLI recommends that the Board add a cost option alternative within the insurance contracts standard.

Not only is the concern about misalignment with IFRS 9, but also the potential volatility and mismatch of the changes in the value of assets measured at fair value and the change in the value of insurance liabilities measured at current fulfillment value. For example, where cash flows of the asset portfolio align with the cash outflows of the insurance liabilities, changes in interest rate spreads may not affect the assets and liabilities in the same way. Other trade organizations and insurers have expressed similar views.

1

IFRS 9:

To develop a cost option for insurance contracts, an appropriate starting point would be IFRS 9. The following sections have been extracted to help frame the cost option proposal.

Chapter 4 Classification

4.1 Unless paragraph 4.5 applies, an entity shall classify financial assets as subsequently measured at either amortised cost or fair value on the basis of both:

(a) the entity's business model for managing the financial assets; and

(b) the contractual cash flow characteristics of the financial asset.

4.2 A financial asset shall be measured at amortised cost if both of the following conditions are met:

(a) the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows.

(b) the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.1

Classification

The entity's business model for managing financial assets

B4.1 Paragraph 4.1(a) requires an entity to classify financial assets as subsequently measured at amortised cost or fair value on the basis of the entity's business model for managing the financial assets. An entity assesses whether its financial assets meet this condition on the basis of the objective of the business model as determined by the entity's key management personnel (as defined in IAS 24 Related Party Disclosures).

B4.2 The entity's business model does not depend on management's intentions for an individual instrument. Accordingly, this condition is not an instrument-by-instrument approach to classification and should be determined on a higher level of aggregation. However, a single entity may have more than one business model for managing its financial instruments. Therefore, classification need not be determined at the reporting entity level. For example, an entity may hold a portfolio of investments that it manages in order to collect contractual cash flows and another portfolio of investments that it manages in order to trade to realise fair value changes.

B4.3 Although the objective of an entity's business model may be to hold financial assets in order to collect contractual cash flows, the entity need not hold all of those instruments until maturity. Thus an entity's business model can be to hold financial assets to collect contractual cash flows even when sales of financial assets occur. For example, the entity may sell a financial asset if:

(a) the financial asset no longer meets the entity's investment policy (eg the credit rating of the asset declines below that required by the entity's investment policy);

(b) an insurer adjusts its investment portfolio to reflect a change in expected duration (ie the expected timing of payouts); or

1 Extracted from IFRS 9, Financial Instruments. © IASC Foundation.

2

(c) an entity needs to fund capital expenditures.

However, if more than an infrequent number of sales are made out of a portfolio, the entity needs to assess whether and how such sales are consistent with an objective of collecting contractual cash flows.2

B4.5 One business model in which the objective is not to hold instruments to collect the contractual cash flows is if an entity manages the performance of a portfolio of financial assets with the objective of realising cash flows through the sale of the assets. For example, if an entity actively manages a portfolio of assets in order to realise fair value changes arising from changes in credit spreads and yield curves, its business model is not to hold those assets to collect the contractual cash flows. The entity's objective results in active buying and selling and the entity is managing the instruments to realise fair value gains rather than to collect the contractual cash flows.

B4.6 A portfolio of financial assets that is managed and whose performance is evaluated on a fair value basis (as described in paragraph 9(b)(ii) of IAS 39) is not held to collect contractual cash flows. Also, a portfolio of financial assets that meets the definition of held for trading is not held to collect contractual cash flows. Such portfolios of instruments must be measured at fair value through profit or loss.

Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding

B4.7 Paragraph 4.1 requires an entity (unless paragraph 4.5 applies) to classify a financial asset as subsequently measured at amortised cost or fair value on the basis of the contractual cash flow characteristics of the financial asset that is in a group of financial assets managed for the collection of the contractual cash flows.

B4.8 An entity shall assess whether contractual cash flows are solely payments of principal and interest on the principal amount outstanding for the currency in which the financial asset is denominated (see also paragraph B5.13).

B4.9 Leverage is a contractual cash flow characteristic of some financial assets. Leverage increases the variability of the contractual cash flows with the result that they do not have the economic characteristics of interest. Stand-alone option, forward and swap contracts are examples of financial assets that include leverage. Thus such contracts do not meet the condition in paragraph 4.2(b) and cannot be subsequently measured at amortised cost.3

B4.10 Contractual provisions that permit the issuer (ie the debtor) to prepay a debt instrument (eg a loan or a bond) or permit the holder (ie the creditor) to put a debt instrument back to the issuer before maturity result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(a) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations), or a change in control of the issuer; or

(ii) the holder or issuer against changes in relevant taxation or law; and

2 Extracted from IFRS 9, Financial Instruments. © IASC Foundation.3 Extracted from IFRS 9, Financial Instruments. © IASC Foundation.

3

(b) the prepayment amount substantially represents unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the early termination of the contract.

B4.11 Contractual provisions that permit the issuer or holder to extend the contractual term of a debt instrument (ie an extension option) result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding only if:

(a) the provision is not contingent on future events, other than to protect:

(i) the holder against the credit deterioration of the issuer (eg defaults, credit downgrades or loan covenant violations) or a change in control of the issuer; or

(ii) the holder or issuer against changes in relevant taxation or law; and

(b) the terms of the extension option result in contractual cash flows during the extension period that are solely payments of principal and interest on the principal amount outstanding.

B4.12 A contractual term that changes the timing or amount of payments of principal or interest does not result in contractual cash flows that are solely principal and interest on the principal amount outstanding unless it:

(a) is a variable interest rate that is consideration for the time value of money and the credit risk (which may be determined at initial recognition only, and so may be fixed) associated with the principal amount outstanding; and

(b) if the contractual term is a prepayment option, meets the conditions in paragraph B4.10; or

(c) if the contractual term is an extension option, meets the conditions in paragraph B4.11.4

B4.15 In some cases a financial asset may have contractual cash flows that are described as principal and interest but those cash flows do not represent the payment of principal and interest on the principal amount outstanding as described in paragraphs 4.2(b) and 4.3 of this IFRS.

B4.16 This may be the case if the financial asset represents an investment in particular assets or cash flows and hence the contractual cash flows are not solely payments of principal and interest on the principal amount outstanding. For example, the contractual cash flows may include payment for factors other than consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time. As a result, the instrument would not satisfy the condition in paragraph 4.2(b). This could be the case when a creditor's claim is limited to specified assets of the debtor or the cash flows from specified assets (for example, a 'non-recourse' financial asset).

B4.17 However, the fact that a financial asset is non-recourse does not in itself necessarily preclude the financial asset from meeting the condition in paragraph 4.2(b). In such situations, the creditor is required to assess ('look through to') the particular underlying assets or cash flows to determine whether the contractual cash flows of the financial asset being classified are payments of principal and interest on the principal amount outstanding. If the terms of the financial asset give rise to any other cash flows or limit the cash flows in a manner inconsistent with payments representing principal and interest,

4 Extracted from IFRS 9, Financial Instruments. © IASC Foundation.

4

the financial asset does not meet the condition in paragraph 4.2(b). Whether the underlying assets are financial assets or non-financial assets does not in itself affect this assessment.

B4.18 If a contractual cash flow characteristic is not genuine, it does not affect the classification of a financial asset. A cash flow characteristic is not genuine if it affects the instrument's contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur.

B4.19 In almost every lending transaction the creditor's instrument is ranked relative to the instruments of the debtor's other creditors. An instrument that is subordinated to other instruments may have contractual cash flows that are payments of principal and interest on the principal amount outstanding if the debtor's non-payment is a breach of contract and the holder has a contractual right to unpaid amounts of principal and interest on the principal amount outstanding even in the event of the debtor's bankruptcy. For example, a trade receivable that ranks its creditor as a general creditor would qualify as having payments of principal and interest on the principal amount outstanding. This is the case even if the debtor issued loans that are collateralised, which in the event of bankruptcy would give that loan holder priority over the claims of the general creditor in respect of the collateral but does not affect the contractual right of the general creditor to unpaid principal and other amounts due.5

BC30 The objective of the effective interest method for financial instruments measured at amortised cost is to allocate interest revenue or expense to the relevant period. Cash flows that are interest always have a close relation to the amount advanced to the debtor (the 'funded' amount) because interest is consideration for the time value of money and the credit risk associated with the issuer of the instrument and with the instrument itself. The Board noted that the effective interest method is not an appropriate method to allocate cash flows that are not principal or interest on the principal amount outstanding. The Board concluded that if a financial asset contains contractual cash flows that are not principal or interest on the principal amount outstanding then a valuation overlay to contractual cash flows (fair value) is required to ensure that the reported financial information provides useful information. 6

Definitions relating to recognition and measurement

The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility.

The effective interest method is a method of calculating the amortised cost of a financial asset or a financial liability (or group of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, when appropriate, a shorter period to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, an entity shall estimate cash flows considering all contractual terms of the financial instrument

5 Extracted from IFRS 9, Financial Instruments. © IASC Foundation.6 Extracted from IFRS 9, Basis for Conclusions. © IASC Foundation.

5

(for example, prepayment, call and similar options) but shall not consider future credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see IAS 18 Revenue), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably. However, in those rare cases when it is not possible to estimate reliably the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).7

Cost option for insurance contractsTo align the insurance contracts standard with IFRS 9, the ACLI proposes that a cost option should be added to the accounting standard for insurance contracts. The cost option should be conceptually consistent with the amortized cost measurement attribute contained in IFRS 9 and consistent with the building block model proposed in the ED.

Principle for insurance contracts

An entity shall classify insurance liabilities as measured at either cost or current fulfilment value on the basis of both:

(a) the entity's business model is based on the co-ordination of financial assets and insurance liabilities; and

(b) the contractual cash flow characteristics of the insurance liabilities.

Unless the current fulfilment value8 is selected as the measurement approach, an insurance liability shall be measured at cost if the following conditions are met:

TBD based upon decisions about the types of contracts suitable for the cost option

ApplicationNot all products would be suited for a cost option. For example, variable products where the policyholder assumes the investment risk and the investments are in mutual funds measured at fair value may not be a candidate. The entity would identify and disclose the products or range of products that are managed based upon their contractual cash flows and the insurance liability measured under the cost option. Application guidance may be influenced by decisions about revenue recognition, which was not addressed in the ED (see ACLI document of Presentation of the financial statement). For example, if the recommendation is to unbundle deferred annuity contracts with the accumulation component accounted for under IFRS 9, could the remaining insurance component be measured under the cost option?

Measurement at inceptionAt inception, the measurement of insurance contract liabilities under the cost option or current fulfilment value would be the same, i.e., based upon the building blocks model and the underlying assumptions and inputs (unless the PAA method applies).

Subsequent measurement

7 Extracted from IAS 39, Financial Instruments: Recognition and Measurement. © IASC Foundation.8 The guidance for the current fulfillment value approach would be described in the standard.

6

At each reporting period, all assumptions and inputs, except for the discount rate, would be remeasured. The discount rate for the portfolio of contracts, set at inception, would continue unless the underlying asset cash flows (principal and interest) are insufficient to meet the contractual cash flows of the insurance liabilities. At least annually, an asset adequacy test must be performed to ensure the asset cash flows are sufficient. If the test results indicate the cash flows are insufficient, the discount rate is unlocked and remeasured based upon the new set of cash flows.

PresentationIn a cost option model, the expectation is that there would not be any gains or losses since the assets and liabilities would be measured at cost (amortized cost). However, it is likely that companies would sell assets from time-to-time producing gains or losses. An issue that needs to be addressed is how should gains and losses resulting from the sale of investments be presented in the statement of comprehensive income? Should gains and losses be recognized in OCI or profit and loss? If the amounts are reported and accumulated in OCI, should there be recycling?

Questions for the SubgroupIn order to advance the discussion and decision making with respect to the cost option the Subgroup is asked the following questions.

1. Before developing guidance on the cost option, what products would likely benefit by having the option (review table below)?

2. Would decisions about revenue recognition affect the list of products to consider for the cost option?

3. At inception, is the discount rate the only assumption that should be locked-in? If not, what other inputs should be included and why?

4. Should the effective interest method be prescribed for the cost option? If not, why not and what are the alternatives?

5. Should the guidance clarify that embedded derivatives should be unbundled and are there other options that should be unbundled? If yes, what should be unbundled?

6. Do we agree with the subsequent measurement proposed guidance for the cost option? If not, what changes should be made?

7. Are there any issues with other inputs, e.g., acquisition costs that need to be considered in developing the cost option guidance?

8. If investment gains and losses occur related to liabilities measured under the cost option, how should the gains and losses be presented in the financial statements, e.g., OCI?

9. If the discount rate is unlocked, how should the change in value be reported, e.g., OCI?

7

Contract type  

Business objective - Insurance protection or savings

Secondary objective - Insurance protection or savings Unbundling*

Measurement approach-building blocks or Modified approach

cost option measurement choice

Revenue - Presentation

Term insurance, e.g., 10 year, 20 year (non-par) Insurance protection N/A No

building blocks or Modified approach (YRT contracts) Yes

Customer consideration

Traditional Whole life (non-par) Insurance protection savings No building blocks Maybe

Customer consideration

Universal Life Insurance protection savings No building blocks NoCustomer consideration

Variable Life, Variable UL, unit-linked insurance, participating life Insurance protection savings No building blocks No

Customer consideration

Credit Life Insurance protection N/A No building blocks or Modified approach Yes

Customer consideration

Deferred annuities with guarantees Savings Insurance protection Yes

IFRS 9 for savings; building blocks or Modified approach

IFRS 9-savings; maybe for insurance

IFRS 9-savings; customer consideration for insurance

Immediate life income annuities Insurance protection N/A No building blocks Yes

Customer consideration

Disability income Insurance protection N/A No building blocks MaybeCustomer consideration

Contract type   Primary business Secondary business Unbundling* Measurement cost option Revenue -

8

objective - Insurance protection or savings

objective - Insurance protection or savings

approach-building blocks or Modified approach

measurement choice Presentation

Long-term Care Insurance protection N/A No building blocks MaybeCustomer consideration

Health insurance Insurance protection N/A Nobuilding blocks or Modified approach Yes

Customer consideration

Non-life contracts e.g., property/business, auto Insurance protection N/A No

building blocks or Modified approach Yes

Customer consideration

* Do we need to identify contracts containing embedded derivatives or other options that should be unbundled?

9