Life Insurance final - Universiti Kebangsaan Malaysiaaccounting treatment. Also, we will focus into the life and non-life insurance company separately in order to compare the impact

MSc Insurance and Risk ManagementFull Time 2001-2002

Dissertation Topic:

New International Accounting Standard forInsurance Industry

(Life Insurance)

Humaida Banu Samsudin

Supervisor: Prof. Gerry M Dickinson

Co-Written by: Humaida Banu Samsudin Li Hon Wai Anthony

City University Business SchoolMSc Insurance and Risk Management

ii

Acknowledgements

First of all, I would like to express my gratitude to my supervisor, Prof. Gerry M

Dickinson for his instructions, suggestions, ideas and help that he provided for this

dissertation.

Moreover, I would also like to thank Ms Fee Kuen Kow, who had guided and helped

me a lot for the completion of this dissertation. And not forgotten my colleague,

Anthony who has been very supportive and co-operative throughout the completion of

this dissertation.

And finally I would like to thank my family in Malaysia and friends especially, Diara

Md. Jadi and Khor Chooi Lian for all their support and encouragement throughout my

master’s course.

By,

……………………………………..

Humaida Banu Samsudin

MSc Insurance and Risk Management

City University, London


iii

Contents

ACKNOWLEDGEMENTS..................................................................................................II

LIST OF FIGURES AND ILLUSTRATIONS .......................................................................V

ABSTRACT.................................................................................................................... VI

1.0.......................................................................................... INTRODUCTION....................................................................................................................................... 1

1.1 HISTORY.................................................................................................................................................1

1.2 STRUCTURE AND ORGANISATION OF THE IASC...................................................................................3

1.3 AIM OF IAS............................................................................................................................................6

1.4 STEERING COMMITTEE..........................................................................................................................7

2.0 ASSET AND LIABILITY APPROACH.........................................................................12

2.1 ANALYSIS OF THE FOCUS ON THE ASSET LIABILITY APPROACH UNDER IAS. THE CASE OF FOR AND

AGAINST. ....................................................................................................................................................12

2.2 IN THE CASE OF THE “ASSET AND LIABILITY” APPROACH, HOW SHOULD ASSETS AND LIABILITIES

BE VALUED: FAIR VALUE OR ENTITY-SPECIFIC VALUE?.........................................................................13

2.3 IN THE “ASSET AND LIABILITY” APPROACH, SHOULD DISCOUNTING RATES USED TO EVALUATE THE

PRESENT VALUE OF CONTRACTS BE LINKED TO THE RELATED INVESTMENT PORTFOLIO OR NOT? ........16

2.4 IN THE CASE OF THE “ASSET AND LIABILITY” APPROACH, WHAT WOULD BE THE COMPONENTS OF

THE INCOME STATEMENT?.........................................................................................................................17

3.0 FINANCIAL INSTRUMENTS AND INSURANCE CONTRACTS ...................................19

3.1 DISCUSSION OF WHY FINANCIAL INSTRUMENTS ARE TREATED DIFFERENTLY UNDER IAS. ............19

3.2 DIFFERENCES BETWEEN INSURANCE CONTRACTS AND FINANCIAL INSTRUMENTS...........................22

3.3 HOW DO INSURANCE AND BANKS DIFFER? NOTING THAT ASSET AND LIABILITIES BANKS ARE

INCLUDED IN IAS39 ..................................................................................................................................24

3.4 IS THERE A CASE TO SEPARATE OUT INSURANCE CONTRACTS FROM IAS 39. DISCUSSION OF THIS

FOR LIFE AND NON-LIFE INSURANCE CONTRACTS. .................................................................................25

4.0 FAIR VALUE.............................................................................................................28

4.1 THE PROBLEMS WITH CURRENT ACCOUNTING..................................................................................28

4.2 THE FAIR VALUE ISSUE........................................................................................................................29

4.3 SHOULD INSURANCE CONTRACTS BE INCLUDED IN A FAIR VALUE STANDARD?.............................31

5.0 LIFE INSURANCE.....................................................................................................34

5.1 CHARACTERISTIC OF INSURANCE TRANSACTIONS.............................................................................34

5.2 LIFE INSURANCE CONTRACTS.............................................................................................................34

5.2.1 Termination of the Contract .......................................................................................................37

5.2.2 Claims Arising from Events That Have Occurred....................................................................38

5.2.3 Claims during the Period Covered by the Current Premium - Events Have Yet to Occur ....38

5.2.4 The Insurance Contract...............................................................................................................39


iv

5.2.5 Acquisition Costs ........................................................................................................................39

5.2.6 Summary of Assets and Liabilities ............................................................................................40

5.3 LIFE INSURANCE MODEL.....................................................................................................................40

5.3.1 Policyholder-Benefits (Prospective) Model ..............................................................................41

5.3.2 Policyholder-Deposit (Retrospective) Model ...........................................................................43

5.3.3 Models Compared.......................................................................................................................45

5.3.4 The Steering Committee’s view, Financial Statements at Fair Value .....................................46

5.4 LIFE INSURANCE FORMATS.................................................................................................................49

6.0 CASH FLOW ESTIMATION AND DISCOUNT RATE...................................................54

6.1 CASH FLOW ESTIMATION....................................................................................................................54

6.2 ESTIMATING CASH FLOWS AND ADJUSTING FOR RISK AND UNCERTAINTY.....................................54

6.3 EXPECTED PRESENT VALUE OF ALL FUTURE CASH FLOWS..............................................................55

6.4 DISCOUNT RATES .................................................................................................................................60

6.5 FOREIGN CURRENCY CASH FLOWS ....................................................................................................65

7.0 HEDGING INSTRUMENTS.........................................................................................67

7.1 QUALIFYING INSTRUMENTS ................................................................................................................67

7.1.1 Designation of Hedging Instruments .........................................................................................67

7.1.2 Designation of Financial Items as Hedged items......................................................................69

7.1.3 Designation of Non-Financial Items as hedged items ..............................................................69

7.2 HEDGE ACCOUNTING..........................................................................................................................69

7.2.1 Assessing hedge effectiveness ...................................................................................................71

7.2.2 Fair Value Hedges.......................................................................................................................73

7.2.3 Cash Flow Hedges ......................................................................................................................74

7.2.4 Net Investment Hedges...............................................................................................................76

8.0 CONCLUSION...........................................................................................................78

8.1 THE OVER VIEW OF IAS.......................................................................................................................78

8.2 INSURANCE CONTRACTS .....................................................................................................................81

8.3 THE FAIR VALUE DEBATE ..................................................................................................................83

8.4 INSURANCE POLICY.............................................................................................................................86

8.4.1 Life Insurance..............................................................................................................................87

APPENDICES.................................................................................................................88

REFERENCES................................................................................................................97


v

List of Figures and Illustrations

FIGURE 1: Structure Of IASC ...................................................................................... 5

FIGURE 2: The Customers Need From Banks And Insurance Companies ........25

ILLUSTRATION L1: Simple Prospective Model.........................................................42

ILLUSTRATION L2: Policyholder-Deposit Approach ...............................................44

ILLUSTRATION L3: Policyholder-Benefit And Policyholder-Deposit ApproachesCompared....................................................................................................................45

ILLUSTRATION L4: Steering Committee View ..........................................................47

ILLUSTRATION L5: Liability Computation, Asset-Based Discount Rate...............48

ILLUSTRATION L6: Asset-Based Discount Rate ......................................................48

ILLUSTRATION L7: Income Statement – Life Insurance .........................................51

ILLUSTRATION L8: Balance Sheet – Life Insurance................................................52

ILLUSTRATION L9: Cash Flow Statement – Life Insurance ..................................53


vi

Abstract

This dissertation provides the views in the Insurance Paper 1999 developed by

International Accounting Standard Committee’s (IASC) Steering Committee. By the

time the project is complete, a fair value accounting system for assets will be in place

because as a result, liabilities should also be measured at fair values. Insurance

contracts are either financial instruments or should be treated as if they were financial

instruments. Fair value should be based on pools of similar contracts. Given the long-

term nature of insurance contracts and the inherent uncertainties in the projection of

the cash flows, the fair value measurement of insurance liabilities should include

provisions for risk and uncertainty and thereby reflect the risks as perceived by the

market. This dissertation has been divided into two categories (the difference), life

insurance and non-life (general) insurance. No distinction should be made between

general insurance and life insurance in designing a set of accounting standards for all

insurance contracts. It is premature at this stage to recommend disclosure and

presentation details before a better view of the accounting approach to be applied

become available.

Chapter 1: IntroductionNew International Accounting Standard of Insurance Industry


1

1.0 INTRODUCTION

Our aim of this dissertation is to discuss about the importance of the International

Accounting Standard (IAS) to the insurance industry. We will review the

fundamental factors of the IAS to the insurance industry such as the different

accounting needs between financial institutions, ie, bank and insurance companies,

the fair value, matching and hedging issue and the debate of the insurance contracts

accounting treatment. Also, we will focus into the life and non-life insurance

company separately in order to compare the impact of the IAS to the whole business.

After reading this dissertation, the readers should have a clear picture about the pros

and cons of the IAS to the insurance industry and potential problem when it applies in

reality.

1.1 History

Most of the accounting abuses of recent years, such as off balance sheet finance,

‘window dressing’, the presentation of debt as equity and the abuse of reorganisation

provisions, were practised in areas of accounting where there were no authoritative

accounting standards. From the 1920’s experience has shown that, in the absence of

regulation, financial reporting may not give the information that users need to make

informed assessments of companies. Accounting standards aim to promote

comparability, consistency and transparency, in the interests of users of financial

statements. Good financial reporting not only promotes healthy financial markets, it

also helps to reduce the cost of capital because investors can have faith in companies’

reports.

The International Accounting Standards Committee (1973-2001) was the predecessor

body of the IASB. Statements of International Accounting Standards issued by the

Board of the International Accounting Standards Committee (1973-2001) are

designated ‘International Accounting Standards’ (IAS).

IASC was founded in June 1973 as a result of an agreement by accountancy bodies in

Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United

Kingdom and Ireland and the United States of America, and these countries

constituted the Board of IASC at that time.



2

The Commission’s Communication, EU Financial Reporting Strategy: The Way

Forward, proposes the all EU companies listed on a regulated market (including banks

and other financial institutions) should be required to prepare consolidated accounts in

accordance with IAS. It is intended that this requirement will be effective by 2005 at

the latest.

The international professional activities of the accountancy bodies were organised

under the International Federation of Accountants (IFAC) in 1977. In 1981, IASC

and IFAC agreed that IASC would have full and complete autonomy in the setting of

international accounting standards and in the issue of discussion documents on

international accounting issues. At the same time, all members of IFAC became

members of IASC. This relationship continued until the IASC’s Constitution was

changed in May 2000 as part of the reorganisation of the IASC at which time this

membership link was discontinued.

In April 1997 the Board of the International Accounting Standards Committee (IASC)

approved a proposal the IASC should start a project on Insurance Accounting. This

paper is the result of the first stage in that project. Later on, the International

Accounting Standards Board announced in April 2001 that its accounting standards

would be designated ‘International Financial Reporting Standards’.

In many countries, stock exchange listing requirements or national securities

legislation permits foreign companies that issue securities in those countries to

prepare their consolidated statements using International Accounting Standards.

Principal capital markets in this category are Australia, Germany, and the UK.

Certain countries do not permit companies to use IAS without a reconciliation to

domestic generally accepted accounting principles. Most notable among these

countries are Canada, Hong Kong, Japan and United States.

The IAS regulation represents the biggest change in European financial reporting for

30 years and will make the EU the world's first region to have one common set of

accounting standards. This very important step towards international convergence of

accounting standards will improve the transparency of companies' reported



3

information and provide a key plank in the EU's drive for a single European capital

market.

1.2 Structure and organisation of the IASC

In November 1999, the IASC’s Strategy Working Party presented its final report,

‘Recommendations on Shaping IASC for the Future’, to the IASC Board. The Board

subsequently adopted its recommendations, which were then approved by the member

bodies of the International Federation of Accountants. Under the recommendations,

the IASC has been reorganised as a separate body, somewhat like a Foundation, and is

governed by a board of Trustees. The standard setting part of the restructured IASC is

the International Accounting Standards Board (IASB) which is governed by the Board

of Trustees. The Trustees were appointed during the second half of 2000 by a

Nominating Committee that was set up for that sole purpose under the Chairmanship

of the then US SEC Chairman, Mr. Arthur Levitt. There are nineteen Trustees from

diverse geographic and career backgrounds, under the Chairmanship of Mr.Paul A.

Volcker, a Former Chairman of the US Federal Reserve Board.

The first act of the Board of Trustees was to appoint Sir David Tweedie (who had just

completed a highly distinguished period of ten years as the Chairman of the UK’s

Accounting Standards Board) as the first Chairman of the IASB. Subsequently in

February 2001 the Trustees appointed the other members of the IASB. The Trustees

are responsible also for appointing the members of the Standing Interpretations

Committee (SIC) and Standards Advisory Council. The Trustees will also monitor the

IASC’s effectiveness, raise funds for the IASC, approve the IASC’s budget and have

responsibility for constitutional changes.

Set out below is a graphical representation of the new IASC structure, which is

expected to come into effect on or about 1April 2001:

The IASB, which is based in London, comprises fourteen individuals (twelve full-

time Members and two part-time Members), including the Chairman, and has sole

responsibility for setting International Accounting Standards. The foremost

qualifications for Board membership are technical expertise and independence. The

Board Members have representative backgrounds as accounting standard setters,

practising auditors, preparers of financial statements, users of financial statements, or



4

as academics. Seven of the fourteen Board Members have a direct responsibility for

liaison with one or more national standard setters. The publication of a standard,

exposure draft, or final SIC interpretation will require approval by eight of the

Board’s total of fourteen votes.

The Trustees have emphasised their commitment to achieving a broad and

representative balance of perspectives, both professionally and geographically,

through the creation of a Standards Advisory Council. The Advisory Council will

meet regularly with the IASB to advise the Board on priorities and to inform the

Board of implications of proposed standards for users and preparers of financial

statements.

The Standing Interpretations Committee was originally formed in 1997 to consider,

on a timely basis, accounting issues that are likely to receive divergent or

unacceptable treatment in the absence of authoritative guidance. In developing

interpretations, the SIC consults similar national committees which have been

nominated for the purpose by Member Bodies. The SIC has up to 12 voting members

from various countries, including individuals from the accountancy profession,

preparer groups, and user groups. If no more than three of its voting members have

voted against an interpretation, the SIC asks the Board to approve the final

interpretation for issue. The SIC considers the following criteria for taking issues on

its agenda:

• the issue should involve an interpretation of an existing Standard within the

context of the IASC Framework;

• the issue should have practical and widespread relevance;

• the issue should relate to a specific fact pattern; and

• significantly divergent interpretations must either be emerging or already exist in

practice.

The SIC’s function is to give guidance that is generally applicable where existing

Standards are unclear or silent, but not to rule on individual cases. However,

contentious cases brought to the SIC can lead to the issuance of an Interpretation



5

which is applicable on a general basis. As discussed more fully below, full

compliance with all SIC Interpretations is a necessary component of the presentation

of IAS financial statements.

The following diagram is a visual representation of the structure of IASB. The

structure is designed to support those attributes considered desirable to establish the

legitimacy of a standard setting organisation: the representativeness of the decision

making body, the independence of its members, and technical expertise.

IASB's structure provides a balanced approach to legitimacy based upon

representativeness among members of the Trustees, the International Financial

Reporting Interpretations Committee (IFRIC), and the Standards Advisory Council,

and technical competence and independence among Board Members. Also, this is an

analysis of the large body of Information produced by IAS, FASB and external

comments and critiques through letters, email all over the world.

Figure 1: Structure of IASC



6

1.3 Aim of IAS

International Accounting Standard on Insurance Accounting is a need because the

insurance industry is an important, and increasingly international, industry. There is

currently great diversity in accounting practices for insurers. Insurance industry

accounting practices in a number of countries also differ significantly from

accounting practices used by other enterprises in the same countries.

International Accounting Standards do not currently address specific insurance issues

and it is not obvious how an enterprise should deal with these issues under

International Accounting Standards. And certain International Accounting Standards

contain specific scope exclusions in these areas, in recognition of the need for further

study of these issues. Although these gaps cause difficulty for all insurers applying

IAS, they cause a particularly urgent problem in the European Union (EU), where it is

proposed that International Accounting Standards will become mandatory for all

listed enterprises (including listed insurers) by 2005. The existence of such a standard

may help insurance supervisors in their efforts to approach certain aspects of

insurance regulation in ways that are consistent both between countries and with

regulation of the banking and securities sectors.

The Board of IASC (International Accounting Standards Committee) uses IASC’s

Framework for the preparation and presentation of Financial Statements to assist in

the development of International Accounting Standards and in its review of existing

International Accounting Standards. It is also for promoting harmonisation of

regulations, accounting standards and procedures relating to the presentation of

financial statements by providing a basis for reducing the number of alternatives

accounting treatments permitted by International Accounting Standards. The objective

of financial statements is to provide information about the financial position,

performance and changes in financial position of an enterprise that is useful to a wide

range of users in making economic decisions.

Moreover, since May 2000, there have been a number of developments promoting the

use of IAS. These include: (i) the decision of the EU Council of Ministers (ECOFIN

Council) requiring the use of IAS by 2005; (ii) the completion of the reconstitution of



7

the IASB into a full-time independent standard setter, and (iii) the formation of the

Committee of European Securities Regulators with a special sub-group devoted to

these issues.

The International Accounting Standards Board (IASB) published proposals for public

comment in the form of an exposure draft, Improvements to International Accounting

Standards, on which comments are invited by 16 September 2002.

This exposure draft is the first product of the IASB’s Improvements project, which

aims to raise the quality and consistency of financial reporting by drawing on best

practice from around the world, and removing options in international standards. The

Improvements project is a first step by the IASB to promote convergence on high

quality solutions in its objective to establish a globally accepted set of accounting

standards.

1.4 Steering Committee

In 1997, the International Accounting Standards Committee (IASC) set up a Steering

Committee on Insurance. The Steering Committee has published this Issues Paper in

December 1999 for comment by professional accountancy bodies, standard setting

bodies, members of the IASC Consultative Group and other interested individuals and

organisations. The Steering Committee welcome comments on the basic issues and

sub-issues set out in this paper, even if they deal only with a limited number of those

issues. Comments are particularly helpful if they:

(a) indicate the specific basic issues and sub-issues to which they relate;

(b) explain the issues clearly;

(c) provide supporting reasoning; and

(d) indicate which issues are interdependent.

The Steering Committee requests comments by 31 May 2000. The Issues Paper:

• identified the different forms of insurance contract and those specific

characteristics that were considered relevant in determining the appropriate

accounting treatment;



8

• identified the accounting and disclosure issues and arguments for and against

possible solutions to those issues;

• identified the tentative views of the Steering Committee at the early stage of

the project; and

• was published together with an accompanying booklet that contained 82

illustrative examples, summarised relevant national standards and requirements

in 17 countries, summarised the main features of the principal contracts found

in eight countries, contained a glossary of terms used in the paper and

summarised the tentative views expressed in the paper.

The Steering Committee and the Board will review the public response to the Draft

Statement of Principles (DSOP). The Steering Committee will then develop the final

Statement of Principles and submit it to the IASC Board for approval. The Steering

Committee will use the approved Statement of Principles to develop an Exposure

Draft of a proposed International Accounting Standard. On approval by the Board, the

Exposure Draft will be issued for public comment. The Steering Committee will

consider responses to the Exposure Draft and then prepare an International

Accounting Standard for Board approval.

The Steering Committee emphasises that the views expressed in this paper are,

inevitably, tentative at this early stage of the project. Before proceeding to the next

stage of the project, the Steering Committee will review these tentative views

carefully in the light of comment letters received and will assess whether those views

are appropriate. The Steering Committee has not yet discussed its tentative views with

the Board of IASC. The Steering Committee’s tentative views may be summarised

briefly as follows:

(a) the project should deal mainly with accounting for insurance contracts (or groups

of contracts), rather than all aspects of accounting by insurance enterprises. In

particular, the project should not deal with accounting for investments held by

insurance enterprises;

(b) an insurance contract should be defined as a contract under which one party (the

insurer) accepts an insurance risk by agreeing with another party (the



9

policyholder) to make payment if a specified uncertain future event occurs (other

than an event that is only a change in a specified interest rate, security price,

commodity price, foreign exchange rate, index of prices or rates, a credit rating

or credit index, or similar variable);

(c) the objective should be to measure the assets and liabilities that arise from

insurance contracts (an asset-and-liability measurement approach), rather than to

defer income and expense so that they can be matched with each other (a

deferral-and-matching approach);

(d) insurance liabilities (both general insurance and life insurance) should be

discounted;

(e) the measurement of insurance liabilities should be based on current estimates of

future cash flows from the current contract. Estimated future cash flows from

renewals are:

(i) included if the current contract commits the insurer to pricing for those

renewals; and

(ii) excluded if the insurer retains full discretion to change pricing;

(f) in the view of a majority of the Steering Committee, catastrophe and equalization

reserves are not liabilities under IASC's Framework. There may be a need for

specific disclosures about low-frequency, high-severity risks - perhaps by

segregating a separate component of equity;

(g) the measurement of insurance liabilities should reflect risk to the extent that risk

would be reflected in the price of an arm’s length transaction between

knowledgeable, willing parties. It follows that the sale of a long-term insurance

contract may lead in some cases to the immediate recognition of income. The

Steering Committee recognises that some may have reservations about changing

current practice in this way;

(h) overstatement of insurance liabilities should not be used to impose implicit

solvency or capital adequacy requirements;

(i) acquisition costs should not be deferred as an asset;

(j) all changes in the carrying amount of insurance liabilities should be recognised

as they arise. In deciding what components of these changes should be presented

or disclosed separately, the Steering Committee will monitor progress by the

Joint Working Group on Financial Instruments;



10

(k) the Steering Committee is working on the assumption that IAS 39, Financial

Instruments: Recognition and Measurement (refer: Appendix A1), will be

replaced, before the end of the Insurance project, by a new International

Accounting Standard that will require full fair value accounting for the

substantial majority of financial assets and liabilities. The Steering Committee

believes that;

(i) if such a standard exists, portfolios of insurance contracts should also be

measured at fair value. IASC defines fair value as “ the amount for which

an asset could be exchanged or a liability settled between knowledgeable,

willing parties in an arm’s length transaction”;

(ii) in a fair value accounting model, the liability under a life insurance

contract that has an explicit or implicit account balance may be less than

the account balance; and

(iii) determining the fair value of insurance liabilities on a reliable, objective

and verifiable basis poses difficult conceptual and practical issues, because

there is generally no liquid and active secondary market in liabilities and

assets arising from insurance contracts. To avoid excessive detail, this

Issues Paper discusses measurement issues in fairly general terms. The

Steering Committee will develop more specific guidance on measurement

issues at a later stage in the project;

(l) pending further discussion, the Steering Committee is evenly divided on the

effect of future investment margins. Some members believe that future

investment margins should be reflected in determining the fair value of insurance

liabilities. Other members believe that they should not;

(m) for participating and with-profits policies:

(i) where the insurer does not control allocation of the surplus, unallocated

surplus should be classified as a liability; and

(ii) where the insurer controls allocation of the surplus, unallocated surplus

should be classified as equity (except to the extent that the insurer has a

legal or constructive obligation to allocate part of the surplus to

policyholders). Liability classification is the default, to be used unless

there is clear evidence that the insurer controls allocation of the surplus;

(n) for investment-linked insurance contracts, premiums received may need to be

split into a risk component (revenue) and an investment component (deposit);



11

(o) the accounting for reinsurance by a reinsurer should be the same as the

accounting for direct insurance by a direct insurer;

(p) amounts due from reinsurers should not be offset against related insurance

liabilities; and

(q) most of the disclosures required by IAS 32, Financial Instruments: Disclosure

and Presentation, and IAS 37, Provisions, Contingent Liabilities and Contingent

Assets, are likely to be relevant for insurance contracts. Some of the disclosures

required by IAS 39, Financial Instruments: Recognition and Measurement, may

not be needed in a fair value context. Other items that may require disclosure are

regulatory solvency margins, key performance indicators (such as sum insured in

life, retention / lapse rates), information about risk adjustments and information

about value-at-risk and sensitivity.

Chapter 2: Asset and Liability ApproachNew International Accounting Standard of Insurance Industry


12

2.0 ASSET AND LIABILITY APPROACH

2.1 Analysis of the focus on the Asset Liability Approach under IAS.

The case of for and against.

There should be a single recognition and measurement approach for all forms of

insurance contracts and the approach should be an asset and liability measurement

approach, rather than a deferral and matching approach (refer Appendix B1).

Most insurance accounting models used in practice today follow the deferral and

matching approach. Examples of deferral and matching approaches are US GAAP and

Margins on Services (used primarily in Australia). The objective of a deferral and

matching approach is to relate claim and expense costs to premium revenue. This

generally has the effect of spreading profits over the lifetime of a contract as services

are provided. In particular, acquisition costs are often deferred and amortised against

future premium receipts.

The asset and liability approach is consistent with the IASC framework, which

establishes criteria for evaluating whether an item should be recognised as an asset or

liability. An asset is defined as “a resource controlled by the enterprise as a result of

past events from which future economic benefits are expected to flow to the

enterprise”. A liability is defined as “a present obligation of the enterprise arising

from past events, the settlement of which is expected to result in an outflow from the

enterprise of resources embodying economic benefits”. Based upon these definitions,

some believe the deferral and matching approach violates these basic principles and

results in deferred costs which do not meet the definition of an asset and deferred

revenues or gains which do not meet the definition of a liability. Strict application

would preclude the deferral of premiums and acquisition costs, or the establishment of

equalisation or catastrophe reserves. As the name would suggest, an asset and

liability measurement approach is one that measures the assets and liabilities of an

entity and recognises profit through the relative change in these two quantities from

one year to the next. The embedded value method would be an example of such an

approach.



13

The June 2001 draft DSOP (Draft Statement of Principles) proposes an asset and

liability approach. The reasons for this are as follows (essentially these refer back to

the original objectives of the IASB project):

• an asset and liability approach will provide greater transparency

• an asset and liability approach will produce accounts that are more understandable

• an asset and liability approach will make it easier for users to make comparisons

between different sets of accounts.

This approach would create major changes in financial reporting for all insurers in the

world, which currently apply some variation of the deferral and matching approach.

Significant issues arise as to the contents and format of the statement of financial

performance and ensuring that the information is relevant to the users of financial

statements. Under this approach, a main component of the income statement for

insurers would be the change in financial assets and financial liabilities.

2.2 In the case of the “Asset and Liability” approach, how should assets

and liabilities be valued: Fair Value or Entity-Specific Value?

Insurance assets and liabilities should be measured on a prospective basis, reflecting

the present value of all future cash flows and arising from the closed book of

insurance contracts in existence at reporting date. The prospective approach is

defined in contrast to the retrospective approach, which is the current method used by

the majority of insurers when evaluating insurance liabilities. The retrospective

approach focuses on an accumulation of past transactions between policyholders and

insurers. It relies primarily on objectively recorded transactions. In contrast, the

prospective approach would focus on expected future cash inflows and outflows from

an insurance contract. The objective is consistent with the IASC framework of

providing information that helps users to evaluate the ability of an enterprise to

generate cash and cash equivalents. It is proposed that present value principles could

be used in measuring all insurance assets and liabilities, except where the time value

of money and uncertainty do not have a material effect (e.g. cash flows less than 1

year). This is based on the following assertions:

a) Present value measures are more relevant to investors;

b) Most life insurance measurements use present value calculations;



14

c) It is consistent with rational pricing decisions;

d) It matches revenues and expenses by measuring them in terms of a common

measuring unit.

This DSOP prescribes two methods of prospective measurement, without indicating a

preference at this stage for one or the other. The Standard should require only one of

these methods.

Under the first method, insurance liabilities and insurance assets should be measured

at entity-specific value. Entity-specific value represents the value of an asset or

liability to the enterprise that holds it, and may reflect factors that are not available (or

not relevant) to other market participants. In particular, the entity-specific value of a

liability is the present value of the costs that the enterprise will incur in settling the

liability in an orderly fashion over the life of the liability.

Under the second method, insurance liabilities and insurance assets should be

measured at fair value. Fair value is the amount for which an asset could be

exchanged or a liability settled between knowledgeable, willing parties in an arm’s

length transaction. In particular, the fair value of a liability is the amount that the

enterprise would have to pay a third party at the balance sheet date to take over the

liability.”

IAS currently does not use the term entity-specific value. In developing a definition of

entity-specific value, the Insurance Steering Committee referred to two precedents.

The June 2001 draft DSOP adopted the definition proposed by the former IASC

Present Value Steering Committee. This Steering Committee defined entity-specific

value as “the value of an asset or liability to the enterprise that holds it”. This is a

generalisation of the notion of value in use, defined in IAS 36, Impairment of Assets,

as “the present value of estimated future cash flows from the continuing use of an

asset and from its disposal at the end of its useful life”. The Steering Committee also

defined entity-specific value of a liability as “the present value of the costs that the

enterprise will incur in settling the Liability in an orderly fashion over the life of the



15

liability”. This definition builds on a statement in the IASC Framework that the

present value of liabilities is “the present discounted value of the future net cash

outflows that are expected to be required to settle the liabilities in the normal course

of business.”

IAS define fair value as “the amount for which an asset could be exchanged or a

liability settled between knowledgeable, willing parties in an arm’s length

transaction”. The fair value of a liability is its fair value in exchange, i.e. the amount

that the enterprise would have to pay a third party at the balance sheet date to take

over the liability. Entity-specific value allows the use of an enterprise’s own costs,

assumptions and experience. Fair value by comparison, requires that an enterprise use

assumptions and expectations inferred from market data.

Even if the insurer and the market have the same level of knowledge about the asset

or liability, the entity-specific value of an asset or liability may differ from its fair

value if:

a) The insurer has superior management skills that enable it to maximise cash

inflows from an asset or minimise cash outflows from a liability

b) They form different estimates about the timing or amount of future cash flows

c) They have different liquidity needs or have different views about the relevance of

their own credit standing.

The fair value concept revolves around the principle of a “transaction”, whereas the

entity-specific value concept is based on the principle of “normal course of business”.

• Usually given arguments for entity-specific value are:

a) Most insurance liabilities are settled by payments to policyholders, rather than

by an exchange transaction with a third party;

b) Management has better information than other market participants about their

company’s future cash flows;

c) Most insurance liabilities are not traded; hence their fair value will not be

observable in the market.



16

• Usually given arguments for fair value are:

a) Market prices are more informative and neutral predictors of future cash flows;

b) Entity-specific value is not determinable on a reliable basis, except by

reference to market data;

c) Fair value should be independent of the entity performing the measurement,

which improves comparability;

d) Future IAS (if based on the JWG draft) could require full fair value accounting

for financial instruments;

e) Fair value of insurance liabilities may not generally be observable directly in

the market, but their fair value can be estimated using reliable models, which

can use observable market data.

What does it mean for the income statement?

The profit or loss will vary based on whether the insurance liability is evaluated under

fair value or entity-specific value. In entity-specific value, the profit or loss for the

year will reflect management’s estimate of future cash flows, based on their unique

circumstances. Fair value would be based on industry averages or market estimates of

future cash flows. The main point is that while results will reflect the impact of

management’s decisions, results will also be impacted significantly by differences

between the actual experience of the company and the market’s expectations. This

will include differences between the assumptions used in the valuation models (e.g.,

interest rates) and the actual variables.

2.3 In the “Asset and Liability” approach, should discounting rates used

to evaluate the present value of contracts be linked to the related

investment portfolio or not?

If substantially all of an insurer’s financial assets are measured consistently on one

basis, that basis should also be adopted for its insurance liabilities. However the

entity-specific value or fair value of insurance liabilities should not be affected by the

type of assets held or by the return on those assets (except where the amount of

benefits paid to policyholders is directly influenced by the return on specified assets,

as with certain participating contracts and unit-linked contracts). With fair value or



17

entity-specific value, the discount rate used will be an adjusted “risk free rate” rather

than the investment return expected over the life of the policy. The conclusion is

based on the belief that the measurement of liabilities should be independent of an

enterprise’s investment strategy, except for participating, unit-linked and variable

contracts. The valuation of insurance contracts will include adjustments for risk and

uncertainty. This may be incorporated into the valuation process by adjusting the

interest rate or the cash flows, but not both. It is consistent with the concept of entity-

specific value, where the measurement of the liability would be dependent on the

enterprise’s cost structure.

What is the impact on the income statement?

For assets invested in interest bearing instruments whose cash flows exactly match the

cash flows of the insurance portfolio, the impact of any movement in the market rates

could be zero. An exception might of course arise from differences in credit quality.

Nevertheless, it is usually hard to achieve a matched cash flow, therefore the profit or

loss of the insurer will also be impacted by any mismatch in duration. Some portion

of the present value of the investment margin may be taken at inception. The income

statement will be impacted by any mismatch in duration between interest-bearing

investments and the related liabilities. For certain participating, unit-linked, and

variable contracts, the June 2001 draft DSOP indicates that the related investments

will be taken into consideration when determining the contract liability. The June

2001 draft DSOP does not currently provide much detail, however, exactly how this is

to be implemented.

2.4 In the case of the “Asset and Liability” approach, what would be the

components of the income statement?

Each year, the income statement could contain the following items:

• For the year then ended the impact of the difference between the actual investment

return and the risk-free discount rate from prior year.

• For the year then ended the impact of the change in the risk free rates year to year.

• Modifications of assumptions, if any, that affect the expected amount or timing of

future cash flows.



18

• Present value of part of expected profit or loss of new business for the year (the

level of profit or loss will be linked to the level of risk and uncertainty).

• The impact of differences between market expectations and actual results.

• The variation on the appreciation/depreciation of risk and uncertainty each year

would impact the income statement directly.

• In order to be understandable and useful for the users, financial statements would

need to be very detailed. Hence the format of the income statement and related

disclosure is a significant unresolved issue. The June 2001 draft DSOP to date has

a strong balance sheet focus, with less consideration having been given to the

income statement presentation.

Chapter 3: Financial Instruments and Insurance ContractsNew International Accounting Standard of Insurance Industry


19

3.0 FINANCIAL INSTRUMENTS AND INSURANCE CONTRACTS

3.1 Discussion of why Financial Instruments are treated differently

under IAS.

IAS applies to financial instruments. Under this Standard, financial assets are

classified into 4 areas: loans and receivables originated by the enterprise, available-

for-sale, trading and held-to-maturity. Given the definition of held-to-maturity

financial assets, there is a high probability that this category has limited use for

insurance companies in practice. Also, loans and receivable originated by insurance

enterprises usually do not represent a significant portion of their financial assets.

A fundamental issue is whether the project should cover all aspects of accounting by

insurers (in other words, insurance enterprises) or whether it should focus mainly on

insurance contracts of all enterprises. Some argue that the project should deal with all

aspects of financial reporting by insurers to ensure that the financial reporting for

insurers is internally consistent.

Also some argues that the project should cover insurance contracts of all enterprises

because it would be extremely difficult, and perhaps impossible, to create a robust

definition of insurance enterprise that could be applied consistently from country to

country. Also, it would be undesirable for an insurer to account for a transaction in

one way and for a non-insurance enterprise to account in a different way for the same

transaction. Besides, a set of internally consistent accounting requirements for

insurers will be obtained if the accounting requirements for insurance contracts are

consistent with other International Accounting Standards.

The specific Standard for insurance would be restricted to prescribe accounting for

insurance contracts only, and would not apply to other aspects of insurance

companies’ operations. Accounting for insurance contracts should be consistent

among issuers (including insurers and reinsurers) and policyholders.

IAS 32 defines a financial instrument as ‘any contract that gives rise to both a

financial asset of one enterprise and a financial liability or equity instrument of

another enterprise.’ It defines a financial asset as ‘any asset that is: a) cash, b) a



20

contractual right to receive cash or another financial asset from another enterprise, c)

a contractual right to exchange financial instruments with another enterprise under

conditions that are potentially favourable or d) an equity instrument of another

enterprise.’ It defines a financial liability as ‘any liability that is a contractual

obligation: a) to deliver cash or another financial asset to another enterprise or b) to

exchange financial instruments with another enterprise under conditions that are

potentially unfavourable.’

The following definition of insurance contracts is currently used in IAS 32, Financial

Instruments (Disclosure and Presentation), IAS 39, Financial Instruments

(Recognition and Measurement) and the March 1997 Discussion Paper, Accounting

for Financial Assets and Financial Liabilities. An insurance contract is a contract

under which one party (the insurer) accepts an insurance risk by agreeing with another

party (the policyholder) to compensate the policyholder or other beneficiary if a

specified uncertain future event (the insured event) adversely affects the policyholder

or other beneficiary (other than an event that is only a change in one or more of a

specified interest rate, security price, commodity price, foreign exchange rate, index

of prices or rates, a credit rating or event or similar variable).

Insurance assets and insurance liabilities are assets and liabilities arising under an

insurance contract. An insurer or policyholder should recognise:

(a) an insurance asset when, and only when, it has contractual rights under an

insurance contract that result in an asset; and

(b) an insurance liability when, and only when, it has contractual obligations under an

insurance contract that result in a liability.

It is also a contract that exposes the insurer to identified risks of loss from events or

circumstances occurring or discovered within a specified period, including death, (in

the case of an annuity, the survival of the annuitant), sickness, disability, property

damage, injury to others and business interruption. Most insurance contracts are

financial instruments, as defined in International Accounting Standards, because they

create contractual rights or obligations that will result in the flow of cash or other

financial instruments.



21

This definition draws out the important distinction between insurance risk and

financial risk. Contracts, which currently have the legal form of insurance contracts,

can have quite different levels of insurance and financial risk. At one end of the

spectrum a non-linked term assurance product has significant insurance risk, through

the level of life cover offered, but little financial risk. This product would clearly meet

the IASB definition of an insurance contract. At the other end of the spectrum a UK-

style regular premium unit-linked personal pension product has significant financial

risk, but no obvious insurance risk. According to the IASB definition this type of

product would not be an insurance contract. Between these two extremes lie a

multitude of other products. For example, unit-linked contracts with guaranteed death

benefits have both financial and insurance risk and would probably be classed as

insurance contracts.

The meaning of this statement depends greatly on the meaning attributed to the word

‘significant’. The definition’s interpretational sensitivity raises a number of interesting

possibilities. For example, one could envisage a situation where an insurance

company has some of its products classified as insurance contracts, and reports for

them under the insurance accounting standard, and other similar products that do not

meet the definition of insurance contracts and are therefore reported under a different

accounting standard (presumably IAS 39).

It follows that the definition of insurance contracts will serve two functions to provide

a demarcation from other financial instruments on the basis of some attribute that

suggests the need for a separate standard and to distinguish insurance contracts from

other items that are not financial instruments (for example, provisions cover by IAS

37 and intangible assets covered by IAS 38).

Under this definition, many contracts currently sold by insurance enterprises and

accounted for as insurance contracts could fail to meet the proposed new definition of

insurance. For example, a contract that exposes the issuer to financial risk with

insurance risks would not be accounted for as an insurance contract. This could mean

that a significant portion of existing European products might have to be accounted

for as financial instruments in accordance with IAS 39. Most investment-oriented



22

products would no longer be accounted for as insurance. This would mean that

premium received will be a financial liability rather than recognised as revenue by the

issuer and premium paid will be a financial asset (deposit) of the owner.

An insurance contract specifies the contractual rights and contractual obligations that

give rise to insurance assets and insurance liabilities. The event that creates insurance

assets and insurance liabilities is becoming a party to the insurance contract. This

gives the insurer and the policyholder control over their contractual rights and creates

contractual obligations that allow them little, if any, discretion to avoid the net cash

outflows resulting from their contractual obligations.

Also, the new definition includes the notion of ‘uncertain future event.’ It means

uncertain at the inception of a contract whether: a future event specified in the

contract will occur, when the specified event will occur and how much the insurer

will need to pay if the specified future event occurs.

3.2 Differences between insurance contracts and financial instruments.

There would seem to be a number of important differences between insurance

contracts and financial instruments:-

1) Insurance contracts operate on the pooling principle,

2) Financial instrument are normally traded actively on a market and financial

instruments that are assets can be sold at any time and financial instruments that

are liabilities can be redeemed at any time. This is not the case with insurance

liabilities,

3) The amount of administration or servicing required on financial instruments is

normally small or practically non-existent but insurance contracts have a

significant servicing element throughout their lives. In the UK some 40% of the

yearly expenses of insurance companies go on servicing existing contracts,

4) Taking out most of the profits up-front at point of sale in respect of a financial

instrument with minimal servicing requirements (which is the effect of a

measurement at fair value) seems reasonable since the financial instrument can



23

be sold and the profit realised. It seems more debatable whether to take out most

of the potential future profits (i.e. all profits apart from a ‘systematic risk

margin’ or ‘market value margin’) at the point of sale of an insurance contract

when a significant percentage of the cost or work involved with the contract

occurs during the course of its lifetime,

5) Fees earned as services are provided, even for financial instruments, are

recognised as revenue as the services are provided. This would seem to support

the case for not taking out too much of the profits on an insurance contract at

point of sale,

6) The provision of insurance coverage can be regarded as a form of service

provided by the insurer to the policyholder over the term of the contract,

7) The terms of insurance contracts can include services to the policyholder, in

addition to the risk cover. Additional services can be delivered by managing the

investments relating to a life insurance contract where the benefits are linked to

investment performance. The service and financial instrument aspects cannot be

objectively separated in many contracts,

8) The underlying risk from holding insurance contracts is different from most

financial instruments, whereas the holding of a financial instrument usually

results in market and credit risk only, the insurer is also exposed to insurance

risk over a period of time until the contracts expire and claims are settled.

The Issues Paper is predicated on the assumption that IAS 39 will be replaced by a

new standard for financial instruments requiring fair value for the substantial

majority. Insurance contracts would then follow on behind being designated financial

instruments and therefore measured at fair value. It would seem that adoption of this

stance could leave the Steering Committee on Insurance with a difficulty if the new

Financial Instrument Working Group proposed fair value except for those cases which

had the closest parallel with insurance contracts. It is perhaps revealing that FASB’s

document ‘Preliminary Views on major issues related to Reporting Financial

Instruments and Certain Related Assets and Liabilities at Fair Value’ says in

paragraph 4 “….the Board has not yet decided when, if ever, it will be feasible to

require essentially all financial instruments to be reported at fair value in the basic

financial statements”



24

The cases which appear to have been causing FASB most concern are credit card

relationships and demand deposit relationships. The reason that they question the use

of fair value in these cases is the absence of a market for trading the financial

instrument parts of these relationships independent of the value (goodwill or franchise

value) of selling new business and other ancillary benefits to the new customers

acquired. Exactly the same situation applies to insurance contracts where the

published prices for the acquisition of a portfolio of policies (where further policies

can be sold to existing or new policyholders) are included in the purchase price.

3.3 How do Insurance and Banks differ? Noting That Asset and

Liabilities Banks are Included in IAS39

Typical exposures to some risks are sometimes offsetting between banking and

insurance, as in the case of interest-rate risk. Being intermediaries between depositors

and borrowers, banks by nature have a mismatched position with respect to interest

rates; they tend to have long-term assets (loans) and short-term liabilities (demand

deposits). Consequently, banks have developed considerable skill in managing short-

term interest-rate risk, and in profiting from it.

Conversely, insurance companies generally issue long-term liabilities in connection

with life insurance and for retirement savings and income products. Available assets

are often shorter in duration that the liabilities, creating an exposure to long-term

interest-rate risk, or reinvestment risk. In contrast with banks, insurance companies

traditionally have seen the interest risk as something to be eliminated by matching

rather than as a source of profit, so they have developed expertise in hedging the risk.

Banks and insurance companies can provide each other a partial hedge of their natural

mismatch position.



25

Customer Demand Banks Insurance companies

1 Protection against interest risk

2 Protection against personal risk v

3 Safekeeping of assets v v

4 Asset portfolio Management

5 Information on Financial Markets

6 Inform and Trustworthy advises v v

7 Financial Solution and reducing taxes v

8 Funding for monetary needs v

9 Convenient financial transactions v

Figure 2: The customers need from banks and insurance companies

3.4 Is there a Case to Separate out Insurance Contracts from IAS 39.

Discussion of this for Life and Non-life Insurance Contracts.

In many countries, it is mandatory for prudential reasons to make a distinction

between general insurance (sometimes known as property and casualty insurance or

short-term insurance) and life insurance (sometimes known as long-term insurance).

General insurance contracts typically provide insurance protection for a fixed period

of short duration and enable the insurer to cancel the contract or to adjust the terms of

the contract at the end of any contract period, such as adjusting the amount of

premiums charged and cover provided. General insurance contracts are sometimes

classified as long tail (where claim may not be settled for many years) or short tail.

Life insurance contracts are often of long duration and the insurer often has little or no

ability to adjust the level premiums during the term of the contract.

Some people argue that it is important to develop separate requirements for general

insurance and for life insurance because, although both categories expose an insurer

to risk, the nature of the risks is very different. They also feel that users, preparers

and regulators are familiar with such a distinction and would be surprised if it were

removed.



26

Others argue that it is not helpful to distinguish between general insurance and life

insurance, on the grounds that that:

a) the differences between general insurance and life insurance are more a matter of

degree than of principle. Some general insurance contracts have characteristics

that are more often associated with life insurance contracts. For example, some

general insurance contracts require that insurer to provide coverage for ten years

at rates specified at inception. Similarly, a one-year non-renewable term

insurance contract may resemble a typical general insurance contract rather than a

typical life insurance contract;

b) it is important that the same principles should be used for both general insurance

and life insurance;

c) it is not always clear whether a particular type of contract should be classified as

life insurance or general insurance. Indeed, different jurisdictions draw the

boundary between general insurance and life insurance in different places. This

may make it difficult to make the distinction in a consistent way.

Some argue that a distinction between general insurance and life insurance is less

relevant that a distinction between short-term contracts and long-term contracts,

perhaps using a twelve-month cut off.

The Steering Committee proposes to make the distinction for financial reporting

purposes where insurance should be treated as general insurance for financial

reporting purposes if the insurer is committed to a pricing structure for not more than

twelve months. And insurance should be treated as life insurance for financial

reporting purposes if the insurer is committed to a pricing structure for more than

twelve months. The (financial instruments) Steering Committee has concluded that

the general principles proposed are relevant to insurance, and that their financial

assets and financial liabilities should be recognised and measured on the same basis as

those of other enterprises.

There is also argument that the IAS 39 should deal with investments and other

financial instruments (other than insurance contracts) held by insurers, to ensure that

the financial reporting for insurers is internally consistent.



27

Other argue that the IAS 39 should not deal with financial instruments (other than

insurance policies) because:

a) it would be undesirable for an insurance enterprise to account for a transaction in

one way and for a non-insurance enterprise to account in a different way for the

same transaction;

b) the project should not re-open issues addressed by other IASC standards, unless

there are specific features of insurance that justify a different treatment;

c) a set of internally consistent accounting requirements for insurers will be obtained

if the accounting requirements for insurance contracts are consistent with the

International Accounting Standard on the recognition and measurement of

financial instruments.

Chapter 4: Fair ValueNew International Accounting Standard of Insurance Industry


28

4.0 FAIR VALUE

4.1 The problems with Current Accounting

First, in current practice many derivative financial instruments are not recognised.

This is the result of using historical cost accounting for derivatives that have no initial

cost (for example, financial forward contracts, including interest rate swaps). Since

their initial cost is nil, if no recognition is given to changes in their fair values, these

derivatives are effectively invisible. Depending on underlying price movements, such

derivatives can have substantial values and can represent significant risk position that

may transform an enterprise's financial risk profile. Their lack of recognition results

in financial statements that are incomplete.

Second, enterprises increasingly recognise the need to actively manage financial risks

to avoid being excessively exposed to loss as a result of sudden price changes (for

example, in interest rates). The historical cost of financial assets and financial

liabilities has little relevance to financial risk management decision. A system of

accounting that reports the historical costs of these assets and liabilities in published

financial statements lacks relevance and information value for investors attempting to

evaluate enterprise performance, liquidity, and financial risk exposures.

Third, as noted earlier, current practice in many countries uses some form of mixed

measurement, under which some financial instruments are carried at historical cost

and some on a fair value basis. This has caused a series of interrelated problems.

a. It has not been possible to define a sound principle for distinguishing those

financial instruments that are appropriately carried on a cost basis and those that

should be carried at fair value. Instruments to be held for the long term or to

maturity would be measured at cost, those to be held for hedging purposes based

on the hedged position, and other instruments at fair value. Many respondents to

the exposure draft strongly criticised this reliance on management intent. There

was particular concern that it would be inconsistently applied, difficult to audit

and not operational, and that it would not have any sound economic basis. These

criticisms have been borne out by the experiences of national standard setters that

have attempted approaches along these lines.



29

b. A mixed measurement system provides opportunities for abuses, such as selective

recording of sales to manage reported income (sometimes referred to as ‘cherry

picking’). For the reasons stated above, it has proved to be very difficult to

develop a mixed measurement system that is not susceptible to the problem.

c. A mixed measurement system inevitable leads to mismatches, for example, when

an investment portfolio carried on a fair value basis is financed by debt carried on

a cost basis, or when derivatives measured at fair value are used to hedge financial

risk positions that are not recognised or are carried on a cost basis.

4.2 The Fair value issue

The International Accounting Standards Board is in the process of developing a

standard for the reporting of insurance contracts. This standard is commonly referred

to as fair value. The International Accounting Standards definition of fair value is as

follows:

"the amount for which an asset could be exchanged or a liability

settled between knowledgeable, willing parties in an arm's length

transaction"

Over the past year or so fair value accounting has become one of the most topical

subjects for discussion within the insurance industry. The development of this

important subject has been rapid and there has been much discussion in recent months

on the technical issues surrounding fair value and how it should be applied in the

context of insurance business. Fair value is likely to affect many aspects of the

management of a Life Insurance Company and intended to be of use to a variety of

people. These will range from those responsible for performing fair value calculations

to those responsible for solvency reporting, profit forecasting, product design, asset

allocation and the general management of the business. Although the theoretical parts

generally apply to life and non-life business, the practical sections concentrate on life

insurance business.

Although there are some conceptual and practical issues involved in determining the

fair value of an asset, it is reasonably clear what this definition means for an asset. It

is less clear what the fair value of a liability is. There are three possibilities:



30

(a) fair value as an asset (the amount at which others are willing to hold the liability

as an asset);

(b) fair value in settlement with the creditor (the amount that the enterprise would

have to pay to the creditor to extinguish the liability); and

(c) fair value in exchange (the amount that the enterprise would have to pay a third

party at the balance sheet date to take over the liability).

Some argue that the definition of fair value refers to a single amount – the price of a

transaction. On this basis, they believe that the fair value of a liability from the

perspective of the debtor is the same as its fair value (as an asset) from the perspective

of the creditor. In other words, they believe that the fair value of a liability is the

same as its fair value as an asset (the amount at which others are willing to hold the

liability as an asset). Some argue that the fair value of an insurance liability is its

fair value in settlement with the policyholder (the amount that the enterprise would

have to pay to the policyholder to extinguish the liability). They argue that:

(a) because many insurance liabilities are not, and perhaps cannot be, traded, it is

more meaningful to refer to a hypothetical transaction with an actual counter party

– the policyholder – than to a hypothetical transaction with another party; and

(b) IAS 37, Provisions, Contingent Liabilities and Contingent Assets, states that a

provision is measured by reference to “the amount that an enterprise would

rationally pay to settle the obligation at the balance sheet date or to transfer it to a

third party at that time”. This appears to permit reference to either fair value in

settlement or fair value in exchange.

This DSOP takes the view that the fair value of a liability is its fair value in exchange

The definition of fair value in International Accounting Standards implies a

transaction with a party other than the policyholder because:

(a) if the insurance contract permits the insurer or policyholder to terminate its

obligations under the contract for an agreed surrender value, any such termination

reflects a price agreed at the time of entering into the contract, not a current

transaction price;



31

(b) if the insurance contract does not permit the insurer or policyholder to terminate

its obligations under the contract, any settlement will require negotiation with the

other party to the contract. An insurer or policyholder is unlikely to be a willing

party, because it would commence such negotiations only for compelling reasons

that would weaken its bargaining position;

(c) the definition of fair value refers to a hypothetical transaction in which the debtor

transfers its liability to another party, not one in which the creditor transfers its

asset to another party; and

(d) premature settlement with the policyholder contradicts the economic rationale for

insurance, which is based on the insurer’s ability to pool and diversify risks.

4.3 Should Insurance Contracts be Included in a Fair Value Standard?

Many in the insurance industry have expressed concerns about extending fair value

concepts to financial reporting of insurance activities. Some argue that introducing

fair values, which are always current measurements of assets and liabilities, will lead

to reported net profit or loss and equity that are more volatile and less predictable and

manageable than the amounts produced by traditional accounting conventions. In

their view, insurance is a long-term undertaking and the current fluctuations of

financial markets are not representative of that fundamental characteristic of the

industry. They maintain that financial statement users will find financial reporting

more useful if it reflects long-term expectations rather than current information.

Finally, some suggest that year-to-year volatility produced by a fair value approach is

preferable to the large adjustments sometimes produced by long-term approaches.

This group observes that a long-term approach requires the use of accounting

conventions to defer realised and unrealised gains and losses. Those deferrals can

accumulate until the amount is no longer sustainable, even over the long term. The

large adjustments that then become necessary often come as a surprise to financial

statement users.

Insurance contracts are usually settled through performance, rather than transfer, so

some maintain that a measurement based on expected performance over the contract

term is more relevant than fair value. They favour an entity-specific measurement or



32

value in use that incorporates the insurer’s expectations about future cash flows rather

than the market’s expectations. In their view, the insurer’s internal expectations are

more relevant than those of a market that may not exist.

Others disagree because they observe that similar arguments could be made for many

financial assets and liabilities. In their view, any argument for applying value in use

concepts to financial instruments should be applied to all financial instruments, rather

than only to insurance contracts. They also contend that observed market prices, when

available, are more relevant and useful than a company’s internal estimates. They

acknowledge that experience may prove that the company’s estimates were correct

and the market was wrong. However, they suggest that the results of that experience

should be recognised when it happens rather than anticipated in an entity-specific

measurement of the liability.

Some argue that introducing fair value measurements may cause the stockholders of

insurance companies and insurance consumers to behave inappropriately. This group

is concerned that insurance stockholders may conclude that asset gains (whether

realised or unrealised) allow them to receive higher current dividends. Insurance

consumers may conclude that asset losses indicate that they should terminate or not

renew existing insurance contracts, thus creating a “run on the bank.” Those who are

concerned with solvency and confidence point to situations in which apparently weak

companies were able to survive market reverses.

Those who favour use of fair-value measurements argue that financial reporting is one

of many tools that managers, stockholders, and consumers use in decision making.

Good managers know that investments must provide the cash flows necessary to meet

policyholders’ claims, and that changes in fair value may not alter the cash flows

provided by a particular investment portfolio. However, this group also observes that

the failure to use fair value measurements often masks financial difficulty from

financial statement users.

Many industry commentators have remarked on the importance of a consistent

measurement approach for an insurer’s assets and liabilities. However, some

commentators question whether fair value provides the most relevant measurement



33

for either assets or liabilities of an insurance enterprise. They argue that IASC should

consider exemptions from fair value accounting. Such exemptions might apply to

insurance enterprises, insurance liabilities and related assets or insurance liabilities.

The Steering Committee holds the following views, all in the assumed context of a

future International Accounting Standard that requires all financial instruments to be

measured at fair value:

(a) if the other enterprises use fair value for financial instruments, insurers should not

be excluded;

(b) if all other financial assets and financial liabilities of an insurer are at fair value,

insurance contracts should be at fair value;

(c) movements in the fair values of an insurer’s financial assets and liabilities should

be reported in a consistent manner. For example, if some movements in the fair

value of assets are excluded from net profit or loss for the period and reported as a

component of equity, accompanying movements in liabilities should be reported

in the same fashion; and

(d) accounting for insurance contracts at fair value should be covered in the insurance

standard, not in the financial instruments standard.

The Steering Committee assumes that, on the completion of this project, IASC will

have adopted a comprehensive approach to reporting all financial instruments at fair

value, with all movements in fair value reported in the income statement. The

Steering Committee considers consistency between the treatment of assets and

liabilities of an insurance enterprise a precondition for proper reporting. Therefore,

the assets and liabilities arising out of insurance contracts should be measured at fair

value, with all movements in fair value reported in the income statement.

The Steering Committee acknowledges that, at this time, it is often difficult to

estimate the fair value of assets and liabilities created by insurance contracts on a

reliable, objective, and verifiable basis. Therefore, the Steering Committee intends to

develop further guidelines to address estimation.

Chapter 5: Life InsuranceNew International Accounting Standard of Insurance Industry


34

5.0 LIFE INSURANCE

5.1 Characteristic of Insurance Transactions

The purchaser of insurance (the policyholder) makes a payment (the premium) to the

insurer for the insurance contract, with the payment usually made at the inception of

the contract (in general insurance) or periodically throughout the contract term (for

life insurance). The insurer, in turn, promises to pay policyholders if specified events

occur during a period of time defined in the contract. The policyholder usually has

the right to cancel a contract at any time, but may or may not receive any refund of

premiums paid. The insurer usually cannot cancel during its term. While the contract

is in force, the insurer typically provides additional services that include investment

management, claim servicing, litigation support, and loss-control counselling.

Every insurance contract, then, has selling, financial, servicing, and risk elements.

The insurer receives an advance payment- the selling element- that can be invested

until needed to pay claims- the financial element. The insurer also accepts the

obligation to make payments based on uncertain future events and to provide other

services- the risk and servicing elements. The relative importance of those elements

varies between different insurance contracts, but they are always present.

The several differences between general and life insurance contracts create different

accounting problems. The contracts provide different coverage, over different periods

and with different premium structures. Moreover, the accounting models and

conventions for these two categories of insurance have developed separately,

reflecting the historical prohibition (in many jurisdictions) against sales of general and

life insurance contracts by the same enterprise.

5.2 Life Insurance Contracts

Life insurance products include medium to long-term savings products with life cover

attached, whole life products and pure protection products such as term assurance and

critical illness insurance. Savings products include investment bonds and endowment

plans. Each of these products provides a death benefit in addition to the savings

feature. The majority of the business written is with-profits.



35

The traditional life insurance product offered by United Kingdom life insurance

companies was a long-term savings product with a life insurance component and

provided tax advantages in comparison to other savings products. The gradual

reduction of these advantages and increasing sale of single premium life products has

resulted in the distinction between life insurance and other long-term savings products

becoming less important. In the late 1970s or early 1980s insurance companies

introduced unit-linked policies that are becoming increasingly popular.

Life insurance contracts cover mortality, and include life insurance, annuity,

disability, and pension contracts. These contracts usually provide for insurance

coverage over a period of several years and may be financed through periodic

premiums or a single payment on inception. Payments by the insurer on the death of a

policyholder are usually fixed by the contract, although annuity and similar contracts

may require payments over an extended period or until death.

This is different from most general insurance contracts, which are for a fixed period

of short duration, usually one year or less. General insurance contracts do not

typically create rights and obligations in the contract beyond the end of the period

covered by the current premium. In contrast, many life insurance contracts grant the

policyholder valuable rights not usually found in general insurance contracts. The

insurer usually has no right to cancel these policies during their term, although it may

have the right to change the price of some elements of the contract.

The Steering Committee concluded that it should develop accounting models for

general insurance and life insurance that are separate, but based on the same

underlying principles. The Steering Committee also concluded that, for financial

reporting purposes:

(a) insurance should be treated as general insurance if the insurer is committed to a

pricing structure for not more than twelve months. Most general insurance

contracts are for a short term and the insurer is free to change premiums after the

end of the period covered by the current premium, or even to decline to renew the

contract; and

(b) insurance should be treated as life insurance if the insurer is committed to a

pricing structure for more than twelve months. For many life insurance contracts,



36

the insurer has limited or no ability to reset premiums and is required to continue

to provide cover if the policyholder continues to pay premiums. This requirement

to continue providing cover is a source of additional that does not arise in

contracts that do not have this feature.

Life insurance accounting models differ from one another in three ways. They build

on different views of the contract and relationship between the insurer and

policyholder; build on different views of the source and pattern of income earned by

the insurer; and use different assumptions about the inflows and outflows from a book

of contracts and, in some cases, adjustments to those assumptions.

Accounting for life insurance contracts has developed separately from accounting for

general insurance contracts, the Steering Committee began its analysis of life

insurance accounting by considering an insurer’s rights and obligations under a life

insurance contract and whether those individual rights and obligations meet the

definition of an asset or a liability found in the IASC framework. During the term of a

life insurance contract, an insurer may do some or all the following:

a) pay commissions and other costs to initiate the contract

b) receive periodic premiums from policyholders

c) make payments to policyholders who have terminated their contracts, either

through payments of cash surrender value or refunds of unexpired premiums

d) make payments to the estate of policyholders who have died and submitted

claims and payments to surviving annuitants

e) pay costs of administering the contract

f) credit policyholders with increases I contract value and charge policyholder’s

contracts for current-period mortality coverage and administration

g) credit policyholders with dividends or bonuses on participating contracts

The Steering Committee found it useful to evaluate the several features of a life

insurance contracts by considering two sample contracts. Each contract is non-

participating, that is, it does not credit policyholders with dividends.

a) A single-premium whole-life insurance contract. The contract has a single

premium of 18,000 and promises a payment on death of 100,000. The



37

contract cash value accrues interest at a fixed rate of 5.5 percent and is paid

to policyholders on termination of the contract before death.

b) A term-life insurance contract with a fixed annual premium of 900. The

contract pays a death benefit of 100,000, and policyholders who survive to

age 100 receive a 100,000 payment. The contract does not provide for any

accumulated value to the policyholder. A policyholder who misses one

premium payment terminates the contract and loses all rights. The insurer

cannot cancel a contract as long as the policyholder pays premiums.

Various items that some consider to be candidates for recognition as assets or

liabilities are:

(a) an obligation to make payments on termination of the contract by the

policyholder before the death of the insured;

(b) an obligation to make payments as a consequence of insured events that have

occurred;

(c) an obligation to make payments as a consequence of insured events that may

occur during the future period covered by the premium already received;

(d) an obligation to make payments as a result of insured events that may occur in

a period that will be covered by future premiums under existing contracts;

(e) a contractual right to receive future premiums under an existing insurance

contract;

(f) a net contractual right or obligation to receive or pay cash as a result of

existing insurance contracts; and

(g) policy acquisition costs.

5.2.1 Termination of the Contract

Both contracts discussed above require the insurer to make some payment if the

policyholder terminates the contract before the death of the insured. The single

premium contract requires the insurer to pay a cash-surrender value. The term-life

contract requires a pro rata return of the unearned premium for the current period.

(Some term-life contracts do not provide for a refund of premiums.) In each contract,

the insurer has a present obligation that arises as a consequence of a past event. In the

Steering Committee’s view, payments that an insurer is required to make on



38

termination of the contract by the policyholder meet the definition of a liability. The

insurer’s liability on the termination of a contract is relatively clear, whether through

action by the policyholder or the death of the insured party. The insurer’s obligation

to make payments in those situations clearly meets the Framework’s definition of a

liability.

5.2.2 Claims Arising from Events That Have Occurred

In the Steering Committee’s view, payments (including related claim handling costs)

that the insurer is required to make as a consequence of insured events that have

occurred (policyholder deaths) clearly meet the definition of a liability, even though

the claims may not have been reported to the insurer.

5.2.3 Claims during the Period Covered by the Current Premium - Events Have

Yet to Occur

Insurers adopt a variety of contractual arrangements for the payment of premiums.

The typical arrangement involves the payment of a premium at or near the initiation

of insurance coverage, although some contracts provide for deferred or instalment

payments. In exchange for the premium, the insurer agrees to pay claims that arise

during a defined period, referred to the “current premium period”, which is defined as

until death or cancellation and thus covers several years into the future. For the term-

life contract, the current premium period is the remaining term of the one-year

premium. In each case, the insurer has an unavoidable obligation to pay any valid

claim presented by a policyholder or policyholder’s estate.

Some consider the liability for unearned premiums recorded in existing insurance

accounting as an attempt to capture this liability for a written option or service

obligation. Others maintain that unearned premiums are a matching device and that

the balance does not satisfy the definition of a liability. They argue that the event that

triggers the insurer’s obligation for future claims during the premium period is the

death of a policyholder. In their view, until that triggering event occurs, the insurer’s

contractual commitment does not satisfy the definition of a liability. In the Steering

Committee’s view, an insurer’s obligation for claims (including related claim



39

handling costs) arising from insured events that may occur during the period covered

by the current premium meets the definition of a liability and should be recognised as

such.

5.2.4 The Insurance Contract

Many insurance contracts require the policyholder to pay periodic premiums, often

monthly or yearly. Other contracts may not require periodic premiums, but

policyholders routinely renew. However, as a matter of law and contract, an insurer

usually cannot compel policyholders to pay future premiums and the insurer has no

obligation for an insured event that may occur during a period beyond the current

premium period. In the usual case, a policyholder’s failure to pay a renewal premium

simply terminates the contract. In the Steering Committee’s view, the combination of

future premiums, expenses, and claims beyond the current premium period from

contracts create assets or liabilities, which exist as a consequence of a past transaction

(signing the contract) that imposes benefits or sacrifices on the insurer. In the Steering

Committee’s view, contracts that guarantee the policyholder’s right to renew the

contract and that restrict the insurer’s ability to change the amount of renewal

premiums create an asset or liability that would not exist in the absence of such

guarantees or restrictions. These are more common in life insurance than general

insurance contracts and as a result, the Steering Committee observes that most general

insurance contracts do not give rise to assets and liabilities related to premiums and

claims after the end of the current premium period.

5.2.5 Acquisition Costs

The accounting treatment of acquisition costs in life insurance is closely linked to the

measurement of policy liabilities. Some accounting conventions for life insurance

include acquisition costs as part of an integrated approach. In those cases, the

capitalisation and amortisation of acquisition costs is part of the measurement of a net

liability, rather than a separate recognition of acquisition costs as assets.

Steering Committee concludes that acquisition costs for life insurance contracts

should be recognised as an expense, on the basis that they do not meet the

Framework’s definition of an asset. Also, the measurement of insurance liabilities



40

already reflects the future cash flows to be generated by the insurance contract, so the

recognition of an asset would lead to double counting.

5.2.6 Summary of Assets and Liabilities

The Steering Committee concludes that the following assets and liabilities are created

by a non-participating life insurance contract:

a) a liability for payments that an insurer is required to make on termination of the

contract by the policyholder

b) a liability for payments that the insurer is required to make as a consequence of

insured events that have occurred

c) a liability for payments of claims that may occur during the period covered by

the current premium

d) a net contractual right or obligation to receive or pay cash as a result of existing

insurance contracts.

The terms of some life insurance contracts allow for a different decomposition of the

life insurance contract. For example, some contracts such as universal life, variable ,

and indexed contracts allow separate identification of future charges against the

contract for administration and mortality coverage, future interest credits, and future

charges for early termination. The ability to separately identify contract components is

a prerequisite for the policyholder-deposit accounting model discussed later in this

section. However, many contracts (including the term-life contract) do not allow for

this level of analysis.

5.3 Life Insurance Model

Life insurance use accounting models that generally fall into one of two categories

that is the policyholder-benefits (prospective) and the policyholder-deposit

(retrospective). Policyholder-benefits (prospective) models measure the liability for

policyholder benefits by focusing on future premium inflows and outflows for

policyholder benefits and expenses. Policyholder-benefit models usually report the

entire amount of premium as revenue when received and report payments to

policyholders as benefits. As they are used in current practice, most applications of

policyholder-benefit models are consistent with a deferral-and-matching view. The



41

assumptions and techniques are designed to produce a particular pattern of reported

income. The resulting liability balance is the amount necessary to produce that

pattern. As a result, policyholder-benefit models are usually considered consistent

with a deferral-and-matching approach. However, prospective techniques can be used

to provide a direct measurement of the insurer’s liability that is consistent with an

asset-and-liability-measurement approach. Policyholder-deposit (retrospective)

models measure the liability to policyholders based on the accumulation of past

transactions between the insurer and policyholders. Policyholder-deposit models

usually report premiums as increases in a deposit liability. Payments to policyholders

are divided between return of that deposit and net benefit in excess of the deposit.

Policyholder-deposit models are consistent with the asset-and-liability-measurement

view. The insurer’s liability is characterised as a deposit and the pattern of reported

income is largely governed by explicit contractual provisions and reporting to the

policyholder.

Sources: All the illustrations from L1 to L9 are from the Insurance Paper 1999.

5.3.1 Policyholder-Benefits (Prospective) Model

In a policyholder-benefits model, premiums are recognised as revenue on receipt,

with a corresponding entry to record a liability for policyholder benefits and an

expense. Payments on the death of a policyholder or on contract surrender are

reported as benefit expense. The liability for policyholder benefits is a present value,

and it increases as interest accrues to the balance. The liability is increased or

decreased at the end of each period based on the number and, in some applications of

this model, the actuarial expectations of contracts in the book that remain in force.

Policyholder-benefits models are usually applied in a manner consistent with a

deferral-and-matching view. However, there is significant disagreement about the

pattern in which income should be attributed to individual years. Appendix E1, E2,

E3 and E4 portrays the workings of a simple policyholder-benefits model.

Illustration L1 shows financial statements for the first five years of the book’s life,

using the simple prospective method developed in the preceding paragraphs. This

approach is also referred to as a premium method or as premium-driven. If the



42

insurer’s expectations emerge as originally projected, net income will equal a constant

percentage of premium revenues. Accountants who are more familiar with

commercial accounting than insurance accounting may see a similarity between this

method and the instalments sale method sometimes applied in non-insurance

situations in some countries.

Year 1 Year 2 Year 3 Year 4 Year 5

Cash and investments

Beginning balance -1,255 6,009 12,356 18,388

Premiums received 14,000 11,194 9,845 9,051 8,502

Policy expenses -12,277 -1,270 -1,117 -1,027 -965

Benefits and related expenses -421 -1,126 -1,530 -1,687 -2,145

Investment earnings 121 607 1,032 1,426 1,815

Contribution (Distribution) -2,678 -2,141 -1,883 -1,731 -1,626

Ending balance -1,255 6,009 12,356 18,388 23,969

Balance sheets

Cash and investments -1,255 6,009 12,356 18,388 23,969

Deferred acquisition costs 9,712 9,014 8,433 7,909 7,416

Benefit liability -8,457 -15,022 -20,787 -26,295 -31,382

(Equity)/Deficit - 1 2 2 3

Income statements

Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502

Investment income -121 -607 -1,032 -1,426 -1,815

Policy expenses 12,277 1,270 1,117 1,027 965

Change in deferred acquisition

costs -9,712 698 581 524 493

Benefits and related expenses 421 1,126 1,530 1,687 2,145

Change in benefit liability 8,457 6,565 5,765 5,508 5,087

Net (income)/loss -2,678 -2,142 -1,884 -1,731 -1,627

Net income as a percentage of

premium revenue 19.13% 19.14% 19.14% 19.12% 19.14%

Illustration L1 - Simple Prospective Model



43

The financial statements shown above include a line labelled distribution. This

convention removes the assets and liabilities not required by the ongoing book of

business, in this case, the amounts reported as net income. Actuaries use a different

convention in their illustrations to achieve the same purpose, but most accountants

find the fictional “dividend” easier to understand. If actual events occur as expected,

an insurer that uses the prospective or premium model described above will report net

income in a declining pattern, reflecting the declining number of policyholders that

remain in the book and pay premiums.

5.3.2 Policyholder-Deposit (Retrospective) Model

This model is used in some jurisdictions instead of the policyholder-benefit model.

Premiums are recognised as a deposit liability rather than as revenue and this deposit

balance represents the policyholder’s equity in the contract. In some cases, the amount

is communicated in annual reports provided to policyholders. In others, an aggregate

deposit balance is computed for financial reporting purposes, but individual deposit

balances are not communicated to policyholders. In other cases, the policy surrender

value is deemed to represent the policyholder’s deposit balance.

The policyholder deposit model became popular with the advent of policies that

include variable terms and grant a measure of discretion to both the insurer and the

policyholder, while retrospective approaches have existed for some time. Those

policies are variously known as universal life, unit-linked, variable, and indexed

policies. They each include a policyholder account that is used to communicate

activity from period to period and functions much like an account with a bank or

broker, while their terms differ. The policyholder’s premiums are credited to this

account, as are investment earnings, and the account is charged for administration and

mortality protection. If the policyholder surrenders the contract, he or she is entitled to

the balance of the account, less any surrender charges.

A policyholder-deposit model may also have implications for the amounts reported as

revenues and expenses. In some jurisdictions, premiums received by the insurer are

not reported as revenues. Instead, premiums are reported as additions to liabilities.

Revenues include amounts that the insurer charges against the policyholder’s account



44

for mortality coverage, administration, and early termination of the contract. This

form of accounting is similar to the accounting that most banks use for their deposit

liabilities. Appendix E5, E6 and E7 of the accompanying booklet portrays the

workings of a simple policyholder-deposit model. A policyholder-deposit approach

requires a different approach to amortising deferred acquisition costs.

Illustration L2 shows five years of financial statements prepared using a policyholder-

deposit approach. Charges against policyholders are reported as revenue, while

receipts are reported as additions to the policyholder deposit.



Beginning balance - 2,707 10,826 18,213 25,370


Policy expenses -12,298 -1,280 -1,123 -1,031 -969



Contribution (Distribution) 1,284 -1,563 -1,180 -1,017 -963

Ending balance 2,707 10,826 18,213 25,370 32,102

Balance sheets

Cash and investments 2,707 10,826 18,213 25,370 32,102

Deferred acquisition costs 9,718 9,087 8,691 8,385 8,104

Benefit liability -8,391

-

15,089

-

21,311

-

27,369

-

32,993

(Equity)/Deficit -4,034 -4,824 -5,593 -6,386 -7,213

Income statements

Mortality, surrender, and expense charges -6,199 -4743 -3,798 -3,342 -3,102

Investment income -121 -884 -1,369 -1,837 -2303

Recurring policy expenses 1,589 1270 1117 1027 965

Death benefits in excess of account

balance 417 402 393 386 381

Amortization of deferred acquisition costs 970 631 396 306 281

Interest credited to policyholder balances 594 971 1,312 1,649 1,988

Net (income)/loss -2,750 -2,353 -1,949 -1,811 -1,790

Illustration L2-Policyholder-deposit approach



45

5.3.3 Models Compared

The policyholder-benefit and policyholder-deposit approaches are compared and both

approaches lead to an answer that can be analysed as the present value of future cash

flows, but the elements of that computation differ between the approaches.

Cash Flow Policyholder-BenefitApproach

Policyholder-DepositApproach

1. Future premiums Included - computed net

premium in traditional

attribution methods (see

Appendix E2) but may use

gross premium.

Not included (do not affect

account balance) - Gross

premium is credited to

account balance as it

arises.

2. Future amounts assessed

against policyholder's

account for administration

and mortality

Included through the

estimate of benefit

outflows.


account balance) - but

reduce the amount of any

premium deficiency.

3. Future expenses

incurred by the insurer for

policy maintenance,

renewal premiums, claim

handling, etc.

Included. Not included (do not affect

account balance) unless a

premium deficiency exists.

4. Future surrender charges Included through the

estimate of benefit

outflows.

Included to the extend that

they (a) affect the account

balance or (b) where there

is no account balance,

affect the cash surrender,

value.

5. Payments on death of

the insured that represent a

return of policyholder's

account balance


estimate of benefit

outflows.

Included.

6. Payments on death of

the insured in excess of the

policyholder's account

balance


estimate of benefit

outflows.


the account balance)

unless a premium

deficiency exists



46

7. Discount rate Depends on objective and

attribution method.

Rate credited to

policyholder accounts.

Illustration L3: Policyholder-Benefit and Policyholder-Deposit Approaches

Compared

5.3.4 The Steering Committee’s view, Financial Statements at Fair Value

In the Steering Committee’s tentative view, a prospective (policyholder-benefit)

approach is consistent with its view of a life insurance contract as a single set of

interrelated assets and liabilities. The Steering Committee expects that a prospective

approach, applied without restriction based on the retrospective approach, would be

more consistent with an estimate of fair value.

Applying the Steering Committee view, it requires the insurer to compare the amount

computed using a policyholder-deposit (retrospective) approach with the amount

computed using a policyholder-benefit (prospective) approach. In implementing this

approach the policyholder-deposit amount (the minimum liability) is equal to the

account balance that accrues to the benefit of policyholders, after deducting any

surrender charges that would apply if the contracts were terminated prior to the death

of the insured. Unless the insurer has the ability to recover additional amounts from

policyholders who terminate contracts before the death of the insured, the minimum

amount computed under the policyholder deposit approach is zero.

The policyholder-benefit amount represents the present value of expected premium

receipts, less the present value of expected payments to policyholders, payments for

contract administration, and payments for claim handling.

In the Steering Committee’s tentative view, the fair value of a life insurance liability

should be computed using a policyholder-benefit approach, without the policyholder-

deposit limitation.



47

Illustration L4 shows financial statements for the first five years of the book. The

liability in Year 1 is computed using the policyholder-deposit computation because

that generates a higher liability (in this case, nil) than the policyholder-benefit

approach, which generates an asset balance of 309.





Policy expenses -12,298 -1,280 -1,123 -1,031 -969



Contribution (Distribution) 7,528 -2,756 -2,011 -1,680 -1,588

Ending balance 8,951 16,314 23,254 30,100 36,539

Balance sheets


Deferred acquisition costs - - - - -

Benefit liability - -9,174 -17,289 -24,803 -31,744

(Equity)/Deficit -8,951 -7,140 -5,965 -5,297 -4,795

Income statements

Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502

Investment income -121 -1321 -1,753 -2,189 -2,635

Policy expenses 12,298 1,280 1,123 1,031 969

Change in deferred acquisition

costs - - - - -


Change in benefit liability - 9,174 8,115 7,514 6,941

Net (income)/loss -1,423 -945 -836 -1,012 -1,086

Benefit liability

Benefit method 309 9174 17289 24803 31744

Deposit method -5244 -12907 20081 -27288

Illustration L4 - Steering Committee View



48

The Steering Committee did not reach a conclusion about the discount rate to be used

or the role of the insurer’s credit standing in the estimate of fair value. Illustration L5

shows the computations of liability balance using an asset-based discount rate of 7

percent, adjusted for risk to 6 percent.


Present value of future

Premiums 78,899 74,287 69,826 65,482 61,392

Commissions and expenses -8,953 -8,429 -7,923 -7,430 -6,966

Death and surrender benefits -62,634 -67,450 -71,153 -74,455 -77,456

Liability balance 7,312 -1,592 -9,250 -16,403 -23,030

Illustration L5 – Liability Computation, Asset-Based Discount Rate

Illustration L6 shows the resulting financial statements for Years 1 - 5





Policy expenses -12,298 -1,280 -1,123 -1,031 -969


Investment earnings 121 1,321 1,753 2,189 2,635

Contribution (Distribution) 7,528 -2,756 -2,011 -1,680 -1,588

Ending balance 8,951 16,314 23,254 30,100 36,539

Balance sheets


Deferred acquisition costs - - - - -

Benefit liability 7,312 -1,592 -9,250 -16,403 -23,030

(Equity)/Deficit 16,263 14,722 14,004 13,697 13,509

Income statements

Premium revenue -14,000 -11,194 -9,845 -9,051 -8,502

Investment income -121 -1,321 -1,753 -2,189 -2,635

Policy expenses 12,298 1,280 1,123 1,031 969

Change in deferred acquisition costs - - - - -


Change in benefit liability -7,312 8,904 7,658 7,153 6,627

Net (income)/loss -8,735 -1,215 -1,293 -1,373 -1,400

Illustration L6 - Asset-Based Discount Rate



49

5.4 Life Insurance Formats

Illustrations L7-L9 shows how a life insurer might present its balance sheet

(Illustration L7), income statement (Illustration L8) and cash flow statement

(Illustration L9). They present four different approaches - a deferral and matching

approach (based on amounts in Illustration L1), an asset and liability approach (based

on amounts in Illustration L4) and two versions of a fair value approach (based on

amounts in Illustration L6). One fair value approach uses a risk-free discount rate and

the other uses an asset-based discount rate. (The Steering Committee is evenly

divided on whether the fair value of an insurer’s liabilities incorporates the expected

return on the insurer’s assets.)

There are small rounding differences in some Illustrations. Other noteworthy points

are as follows:

(a) the amounts in Illustrations L1, L4 and L6 have been adjusted to include share

capital of 5,000 and additional investment return of 350 (5,000 at 7%) in 1999. No

additional investment return is included in 2000, because total equity in 2000

reflects the amount of capital required by the regulatory regime;

(b) the contribution / distribution amount for 1999 and 2000 is the amount needed to

bring investments held to the amounts of 8,951 and 16,341 respectively, which the

amount is assumed to be required under the hypothetical regulatory regime

underlying Illustrations L4 and L6. It is assumed that this amount is not changed

by the accounting method adopted for external financial reporting. It is also

assumed that no cash is held;

(c) under the asset and liability model, the policyholder-deposit balance in 1999 (nil)

is a higher liability amount than the negative amount (asset) that arises on a

policyholder-benefit basis. In 2000, the policyholder-benefit balance (9,174) is

recognised, because it is higher than the policyholder-deposit balance (5,244) –

see Illustration L4;

(d) Illustration L7 shows the presentation of other operating expenses and of income

taxes (both assumed to be zero in this case); and

(e) this example does not split investment return into portions attributable to

policyholders and portion attributable to stockholders. To illustrate one possible

presentation, the financing section of the income statement includes a line for



50

stockholders’ investment return. The “unwinding” of the discount on policyholder

liabilities is included in the change in policyholder assets (in the operating section

of the income statement); and

(f) the income statement (Illustration L7) assumes that there are no changes in

assumptions.



51

L7 Illustrative Income Statement – Life Insurance

INCOME STATEMENT Deferral/Matching Asset/Liability Fair value (1) Fair value (2) (Risk-free

rate) (Asset-based

rate)31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00

Premiums written 14,000 11,194 14,000 11,194 14,000 11,194 14,000 11,194

Claims expense (421) (1,126) (421) (1,126) (421) (1,126) (421) (1,126)

Expenses incurred (12,277) (1,270) (12,277) (1,270) (12,277) (1,270) (12,277) (1,270)

Deferred acquisition costs 9,712 (699) - - - - - -

Change in policyholder liabilities/ assets (8,457) (6,566) - (9,176) 309 (9,485) 7,312 (8,904)

Other operating expenses - - - - - - - -

Investment return 471 1,321 471 1,321 471 1,321 471 1,321

Net operating income 3,028 2,854 1,773 943 2,082 634 9,085 1,215

Financing:

Stockholders' investment return - - - - - - - -

Profit before tax 3,028 2,854 1,773 943 2,082 634 9,085 1,215

Income Taxes - - - - - - - -

Net profit for the period 3,028 2,854 1,773 943 2,082 634 9,085 1,215

Notes:

1. Other operating expenses and income taxes are nil in this example, but lines are included to illustrate possible presentation

2. This example does not split investment return into portions attributable to policyholders and portion attributable to stockholders.

To illustrate one possible presentation, a line for stockholders' investment return is included in the financing section.



52

L8 Illustrative Balance Sheet – Life Insurance

BALANCE SHEET Deferral/Matching Asset/Liability Fair value (1) Fair value (2) (Risk-free

rate) (Asset-based

rate)31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00 31/12/99 31/12/00

Assets

Investments 8,951 16,314 8,951 16,314 8,951 16,314 8,951 16,314

Rights under life insurance contracts - - - - 309 - 7,312 -

Deferred acquisition costs 9,712 9,014 - - - - - -

Total Assets 18,663 25,328 8,951 16,314 9,260 16,314 16,263 16,314

Liabilities and Equity

Share capital 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000

Contribution/ distribution 2,178 (576) 2,178 (576) 2,178 (576) 2,178 (576)

Retained earnings:

Brought forward - 3,028 - 1,773 - 2,082 - 9,085

Current year result 3,028 2,854 1,773 943 2,082 634 9,085 1,215

Total equity 10,206 10,306 8,951 7,140 9,260 7,140 16,263 14,724

Policyholder liabilities 8,457 15,022 - 9,174 - 9,174 - 1,590

Total equity and liabilities 18,663 25,328 8,951 16,314 9,260 16,314 16,263 16,314



53

L9 Illustrative Cash Flow Statement – Life Insurance

CASH FLOW STATEMENT

31/12/99 31/12/00

Cash flows from operating activities:

Gross premiums received 14,000 11,194

Investment earnings 471 1,321

Gross claims paid (421) (1,126)

Acquisition costs paid (12,277) -

Other operating costs paid - (1,270)

Net cash flows from operating activities 1,773 10,119

Cash flows from investing activities:

Purchase of investments (3,951) (7,365)

Net cash flows from investing activities (3,951) (7,365)

Cash flows from financing activities:

Contribution (distribution) 2,178 (2,754)

Net cash flows from financing activities 2,178 (2,754)

Net increase in cash and cash equivalents - -

Chapter 6: Cash Flow Estimation and Discount RateNew International Accounting Standard of Insurance Industry


54

6.0 CASH FLOW ESTIMATION AND DISCOUNT RATE

6.1 Cash Flow Estimation

The starting point for measuring insurance assets and insurance liabilities should be

the expected present value of all future pre-tax cash flows arising from the closed

book of insurance contracts. Expected value should be the probability weighted

average of all cash flows at a given date, without adjustment for risk and uncertainty.

It is the present value of expected cash flows determined for different scenarios. It

includes probability of lapses and surrenders, as appropriate. Until now, insurance

liabilities were evaluated with a “deterministic” approach. They discounted a single

best estimate of the most likely cash flows using a single discount rate intended to

reflect the risks specific to the asset or liability. The proposed approach in the June

2001 draft DSOP is a “stochastic” approach. This allows the valuation process to

separately address the uncertainty around the amount and timing of cash flows and the

term structure of interest rates. It is supposed to capture the full range of possible

outcomes and the shape of their probability distribution. The expected present value

approach is a much more sophisticated approach than that previously used in

accounting models. Implementation issue: It may be a challenge for some insurance

companies to implement such methodology within the required time frame.

6.2 Estimating Cash Flows and Adjusting for Risk and Uncertainty.

Liability valuation begins with projections of expected cash flows under an insurance

contract. The present value of those cash flows, discounted at the risk-free rate, is the

liability value before any adjustment for risk and uncertainty. Both fair value and

entity-specific value should always contain a market-based adjustment for risk. Under

the DSOP, that risk adjustment is made by adjusting the cash flows (the preferable

approach), adjusting the discount rate, or both, without double counting.

The risk adjustments are referred to as "market value margins" and should be

consistent with market-risk preferences. The market-based adjustment for risk and

uncertainty effectively acts as a market mechanism for pricing uncertainty and will

have an impact on liability valuation levels. However, there is no guidance in the

DSOP on how these margins should be determined.



55

6.3 Expected Present Value of All Future Cash Flows

The starting point for measuring insurance assets and insurance liabilities should be

the expected present value of all future pre-income-tax cash flows arising from the

contractual rights and contractual obligations associated with the closed book of

insurance contracts. Those cash flows include estimates of future:

(a) payments to policyholders (including payments to other parties on behalf of

policyholders) under existing contracts, and related claim handling expenses;

(b) premium receipts from policyholders under existing contracts, including

retrospective adjustments to premiums;

(c) future policy loans to policyholders, and repayments by policyholders of

principal and interest on current and future policy loans;

(d) transaction-based taxes and levies relating to existing contracts;

(e) policy administration and maintenance costs; and

(f) recoveries, such as salvage and subrogation, on unsettled claims and potential

recoveries on future claims covered by existing insurance contracts.

These principles refer to contractual rights and contractual obligations. Such rights

and obligations may be:

(a) legal rights and obligations arising from the explicit terms of the insurance

contract;

(b) legal rights and obligations arising from the explicit terms of the insurance

contract in conjunction with legislative, regulatory or other legal requirements;

(c) constructive obligations flowing from the legal obligations in (a) or (b). Some

refer to constructive obligations of this kind by such terms as “policyholders’

reasonable expectations”. Under IAS 37, Provisions, Contingent Liabilities and

Contingent Assets, a constructive obligation arises when:

i) by an established pattern of past practice, published policies or a

sufficiently specific current statement, the enterprise has indicated

to other parties that it will accept certain responsibilities;

ii) as a result, it has created a valid expectation on the part of those

other parties that it will discharge those responsibilities.



56

Rights or obligations that make up financial instruments are derived from the

contractual provisions that underlie them. The term “contractual” refers to an

agreement between two or more parties that has clear economic consequences that the

parties have little, if any, discretion to avoid, because the agreement is enforceable at

law. Contractual rights and obligations, and thus financial instruments, are created by

contracts that may take a variety of forms including written or oral agreements and

contracts implied by an enterprise’s actions or by virtue of custom or practice.

These principles also refer to a starting point because the principles do not address

adjustments that could be made to cash flows to reflect risk and uncertainty.

Sometimes, an insurer stops writing some or all types of contract and allows the

existing books of insurance contracts to run off. When a book of insurance contracts

goes into run-off, the cash flows from that book may change because of, for example,

changes in expense levels, lapse rates, claims management procedures or tax status.

Although the principles and other parts of this DSOP refer to the closed book,

measurement of a closed book reflects run-off assumptions if, and only if, this is a

reasonable and supportable estimate of what will occur. Those principles address all

the future cash flows that may arise from existing insurance contracts. This DSOP

takes the view that the contractual rights and contractual obligations under a book of

insurance contracts form components of a single net asset or liability, rather than

separate assets and liabilities.

Accounting applications of present value have traditionally been deterministic. In

other words, they discounted a single point estimate of the most likely cash flows,

using a single discount rate intended to reflect the risks specific to the asset or

liability. Those who support a deterministic approach argue that it is the most

common method used today, is simple to understand, does not require statistical

training and may be easier to develop than the stochastic approaches. It also captures

uncertainties in amount and timing by simple methods that refer to observable market

returns on comparable assets and liabilities and leads to informative and concise

disclosure because disclosure of the deterministic discount rate reveals the overall

effect of assumptions about uncertainties of amount and timing and this discount rate

can be compared with observable market benchmarks.



57

The expected present value is the estimated probability-weighted arithmetic average

(also known as the expected value or mean) of the present values arising from each

scenario, without considering any adjustment for risk and uncertainty. This may differ

from the single most-likely result. This DSOP requires an expected present value

approach for the following reasons:

(a) it is a stochastic approach, in other words it captures the full range of possible

outcomes and the shape of their probability distribution;

(b) it differs from the traditional approach by focusing on direct analysis of the

cash flows and on more explicit statements of the assumptions used in the

measurement;

(c) unlike deterministic approaches, which must make an arbitrary assumption

about timing, it can deal with uncertainties about the timing of cash flows;

(d) a deterministic approach has no ready means of capturing correlations

between cash flows and interest rates, for example where lapse rates for life

insurance contracts are sensitive to interest rates. The expected present value

approach captures such correlations by generating various scenarios and

applying a different set of discount rates for each scenario;

(e) it is consistent with IAS 37, Provisions, Contingent Liabilities and Contingent

Assets, which suggests an expected value approach to deal with uncertainties

in amount. IAS 37 is silent on the question of uncertainties in timing.

In some cases, deterministic methods may provide a reasonable and cost-effective

approximation to the expected present value. For example:

(a) for the normal (or Gaussian) distribution, and for other symmetrical

distributions of cash flows that are centred on the most likely cash flows with

no uncertainty in timing, the most likely cash flows are the same as the

expected cash flows, and a single point estimate of cash flows may provide a

reasonable approach;

(b) for short periods, low discount rates, a flat yield curve and cash flows that are

not time-sensitive or interest-rate-sensitive, using the average timing may give

approximately the same result as the expected present value approach.

And in many cases, relatively simple modelling may give a reasonably reliable

answer that falls within a tolerable range of precision, without the need for a large



58

number of detailed simulations. However, in some cases, the cash flows may be

driven by complex underlying factors and respond in a highly non-linear fashion to

changes in economic conditions, for example if the cash flows reflect a series of inter-

related implicit or explicit options. In such cases, more sophisticated stochastic

modelling may be required.

In applying those principles, cash flows arising from the contractual rights and

obligations associated with the closed book of insurance contracts should include cash

flows from future renewals to the extent, and only to the extent, that their inclusion

would increase the measurement of the insurer’s liability and policyholders hold

uncancellable renewal options that are potentially valuable to them. A renewal option

is potentially valuable if, and only if, there is a reasonable possibility that it will

significantly constrain the insurer’s ability to reprice the contract at rates that would

apply for new policyholders who have similar characteristics to the holder of the

option.

In determining entity-specific value, each cash flow scenario used to determine

expected present value should be based on reasonable, supportable and explicit

assumptions that:

(a) reflect:

(i) all future events, including changes in legislation and future technological

change, that may affect future cash flows from the closed book of existing

insurance contracts in that scenario;

(ii) inflation by estimating discount rates and cash flows either both in real terms

(excluding general inflation, but including specific inflation) or both in nominal

terms; and

(iii) all entity-specific future cash flows that would arise in that scenario for the

current insurer, even cash flows that would not arise for other market

participants if they took over the current insurer’s rights and obligations under

the insurance contract;

(b) in relation to market assumptions, are consistent with current market prices and

other market-derived data, unless there is reliable and well-documented evidence that

current market experience and trends will not continue. Such evidence is likely to



59

exist only if a single, objectively identifiable, event causes severe and short-lived

disruption to market prices. In such exceptional cases, the assumptions should be

based on this reliable evidence; and

(c) in relation to non-market assumptions, are consistent with the market assumptions

discussed in (b) and with the most recent financial budgets/forecasts that have been

approved by management. To the extent that those budgets and forecasts are not

current and not intended as neutral estimates of future events, the insurer should

adjust those assumptions. If the budgets and forecasts are deterministic, rather than

stochastic, the entire package of scenarios should be consistent with the budgets and

forecasts.

When fair value is not observable directly in the market, fair value should be

estimated by using the assumptions above, but with two differences, fair value should

not reflect entity-specific future cash flows that would not arise for other market

participants if they took over the current insurer’s rights and obligations under the

insurance. And if there is contrary data indicating that market participants would not

use the same assumptions as the insurer, fair value should reflect that market

information. Some argue that estimates of future cash flows should exclude certain

specified categories of future event, such as changes in legislation, including changes

in tax rates and tax law; technological change (which might be divided into

refinements of existing technology and development of completely new technology);

and regulatory approval, for example of a new drug that may affect the cost of

providing medical benefits.

The future cash flows used to determine entity-specific value or fair value should

include overheads that can be directly attributed to a book of insurance contracts, or

allocated to it on a reasonable and consistent basis. These overheads should include a

reasonable charge for the consumption of all assets used to generate the cash flows

concerned. All other overheads should be excluded.

Some argue that the future cash flows included in present value computations should

be only incremental cash flows that relate directly to the asset or liability under review

and should not include allocation of overheads. They believe that allocations of



60

overheads have no place in cash flow measurements. This DSOP takes the view that it

is appropriate to include allocations of all overheads that can be directly attributed to a

book of insurance contracts, or allocated to it on a reasonable and consistent basis,

because overheads represent just as great an economic burden as incremental cash

outflows and should, therefore, be included in present value computations in the same

way; and the inclusion of overheads does not imply that notional cash flows are

included in a forecast of actual cash flows. Their inclusion is a means of pricing the

actual cash flows on a basis that is consistent with market prices.

Cash flows that are not directly incremental at one level of aggregation or up to one

time horizon may become incremental when viewed at a higher level of aggregation

or up to a longer time horizon. For example, salaries are often not adjustable directly

over a few days or even weeks. Thus, the staff costs attributed to processing a single

transaction may not result in additional salary payments (if the processing does not

result in overtime payments), but the processing of a large number of transactions

may well increase the total number of staff employed.

Consistent with the requirements of IAS 36, Impairment of Assets, for value in use,

this DSOP proposes that estimates of fair value and entity-specific value should be

based on cash flows that include overheads that can be directly attributed to an asset

or liability, or allocated to it on a reasonable and consistent basis. All other overheads

should be excluded. This restriction is necessary to ensure consistent and comparable

application in practice. The inclusion of overheads on such a basis does not justify the

recognition of future operating losses.

6.4 Discount rates

The starting point for determining the discount rate for insurance liabilities and

insurance assets should be the pre-tax market yield at the balance sheet date on risk-

free assets. That starting point should be adjusted to reflect risks not reflected in the

cash flows from the insurance contracts. The currency and timing of the cash flows

from the risk-free assets should be consistent with the currency and timing of the cash

flows from the insurance contracts. Risk-free assets are those assets with readily

observable market prices whose cash flows are least variable for a given maturity and



61

currency. In certain cases, the amount of future cash flows is correlated with interest

rates. The expected cash flow approach captures such correlations by generating

various scenarios and applying a different set of discount rates to each scenario,

consistent with the cash flows for that scenario.

a) Benchmark for the Risk-Free Component of Discount Rates

Although no assets provide certain cash flows, the risk of default is regarded as

minimal for some securities issued by highly creditworthy governments. In addition,

it is not usually possible to find other assets that provide more certain cash flows in

the same currencies than these securities. Although those government securities may

carry other risks, for example, interest rate risk (the risk that interest rates will change)

or inflation risk, such securities are sometimes described as risk-free and the interest

rate paid on such securities is often called the risk-free rate.

The risk-free discount rate reflects the time value of money, without considering the

effect of risk. The Joint Working Group (JWG) Draft uses the term “basic (or ‘risk-

free’) interest” to refer to the amount of interest that compensates the lender for the

time value of money. It may be necessary to determine risk-free discount rates either:

(a) to use directly as the discount rate, if adjustments for risk and uncertainty are made

in the cash flows rather than in the discount rate

(b) as a starting point for determining risk-adjusted discount rates if risk-adjusted rates

are not observable directly in the market.

Some argue that central government securities are the assets that carry the lowest risk

in most economies. Therefore, they believe that government securities are the

appropriate benchmark for determining the risk-free component of discount rates.

Some argue that an insurer should use high-quality corporate bonds as the primary

benchmark for the risk-free component. They accept that some default risk is present

in corporate bonds, but argue that this is likely to be relatively low in high-quality

corporate bonds. In countries where active markets do not exist for corporate bonds,

they would use government securities as a proxy for high-quality corporate bonds.

Others argue that the primary benchmark should be high-quality bonds that have the

most active market in the currency under consideration. In some currencies, this might



62

be central government bonds and in other currencies it might be high-quality

corporate bonds.

Central government securities will often be the most appropriate benchmark for

determining the risk-free component of discount rates. This is because government

securities are generally regarded as carrying the lowest level of default risk in a

particular economy. If there is no active market in government securities, yields on

other high-quality securities would be used as a benchmark

This DSOP takes the view that the discount rate for a liability should reflect the

characteristics of that liability, not the characteristics of some other instrument with

different features. Accordingly, this DSOP does not permit a discount rate for

insurance liabilities based on any of the following:

(a) an insurer’s incremental borrowing rate. Among other things, in many

jurisdictions, policyholders enjoy legal priority over lenders and general creditors.

Thus, an instrument with an observable market yield would not have similar

characteristics, including security, to an insurance liability. It follows that an

incremental borrowing rate derived from such an instrument would not reflect the

characteristics of an insurance liability;

(b) an insurer’s cost of capital. Some argue that using the cost of capital would help

investors by aligning financial reporting with new performance reporting

techniques that focus on shareholder value. However, the cost of capital is

effectively the weighted-average return that investors require across the current

mix of all the insurer’s assets, liabilities and operations. It is highly unlikely to

reflect the risk profile of any individual liability; and

(c) returns on assets held, except where the return on specified assets directly

influences the amount of benefits paid to policyholders, as for certain participating

contracts and unit-linked contracts.

b) Market Yield at the Balance Sheet Date

Discount rates are one type of market assumption. The principles in cash flow

estimation propose that market assumptions should be consistent with current market

prices and other current market-derived data, unless there is reliable and well-

documented evidence that current market experience and trends will not continue.



63

Such evidence is likely to exist only if a single, objectively identifiable, event causes

severe and short-lived disruption to market prices. In such exceptional cases, the

market assumptions should be based on this reliable evidence.

c) Yield Curve

The definition of risk-free assets refers to the maturity of the assets. It follows that a

different risk-free asset, and hence risk-free discount rate, may exist for each maturity.

Nevertheless, some propose the use of a single discount rate for each closed book of

insurance contracts, to avoid complex calculations for cash flows that are expected to

occur in different periods. This DSOP takes the view that the discount rates should

incorporate yield curve effects by reflecting the estimated timing of the cash flows

from an insurance liability. Using the expected present value approach, in principle a

separate discount rate is used for each future time at which a cash flow may occur. In

practice, it may sometimes be acceptable to use a single rate that is believed to result

in a reasonable approximation to the use of separate rates for each period.

In some countries, the central government’s bonds may carry a significant credit risk

and may not provide a useful, stable benchmark basic interest rate for enterprises

issuing financial statements in that reporting currency. Some enterprises in these

countries may have better credit standings and lower borrowing rates than the central

government. In such a case, basic interest rates may be more appropriately determined

by reference to interest rates for the highest rated corporate bonds issued in the

currency of that jurisdiction. There can occasionally be real practical difficulties in

extrapolating the yield curve to the distant future. For example, interest rates in Japan

have been abnormally close to zero for the last few years. Some insurance liabilities

mature many years after the final maturity of the instruments for which market prices

can be readily observed. This has made it extremely difficult to assess at what future

date it would be reasonable to assume a return to market conditions that are more

typical of experience over the past several decades.

In some cases, there may be no deep market in bonds with a sufficiently long maturity

to match the estimated maturity of all the benefit payments. In such cases, an

enterprise uses current market rates of the appropriate term to discount shorter term

payments, and estimates the discount rate for longer maturities by extrapolating



64

current market rates along the yield curve. The total present value of a defined benefit

obligation is unlikely to be particularly sensitive to the discount rate applied to the

portion of benefits that is payable beyond the final maturity of the available corporate

or government bonds. The Steering Committee does not believe that it is practicable

for this DSOP to offer further guidance on this difficulty.

d) Consistency with Cash Flows

It is important to use consistent assumptions in determining discount rates and cash

flows. For example, suppose that the lowest-risk instrument with an observable

market price has a yield of 6%, including a premium estimated at 0.5% in total to

cover both expected defaults of 0.3% and the risk that defaults may exceed 0.3%. This

yield of 6% equates the contractual cash flows with the current market price of the

instrument. These contractual cash flows include cash flows that will not be received

in the 0.3% of cases when there is a default. Therefore, the expected return from the

instruments is 5.7%.

In measuring the insurance liability, an insurer will discount the expected cash flows

(using the expected present value approach) at a discount rate that does not include

the premium for expected defaults. If the discount rate did not exclude this premium,

the discount rate would effectively overstate the expected return on the instruments. It

is also appropriate to exclude the further premium (0.2% in this example) that covers

the risk that actual defaults may exceed 0.3%. This risk relates to the instrument used

as a benchmark and does not reflect the characteristics of the insurance liability. It

follows that the yields used to determine discount rates should be determined after

deducting the estimated premium for expected defaults. To the extent that it is

practicable to estimate them, the yield should also exclude risk premiums for bearing

the risk of variability in defaults or other variations in returns from the instrument

used as a benchmark. The exclusion of the total premium of 0.5% would result in a

risk-free discount rate of 5.5% in this example.

e) Income Taxes

DSOP proposes that insurance liabilities and insurance assets should be measured by

discounting pre-tax cash flows at a pre-tax discount rate. Interest rates and yields

observed in the capital markets are generally expressed on a pre-tax basis. In some



65

markets, interest rates for certain instruments (for example, municipal bonds) have

special tax treatment that may distort market returns on those instruments. If such

instruments are used as a benchmark for determining the risk-free rate, it is important

to eliminate the effect of any such distortions.

6.5 Foreign Currency Cash Flows

Estimated cash flows in foreign currency should be discounted using the appropriate

discount rate for the foreign currency. The resulting present value should be translated

into the measurement currency using the spot rate at the reporting date. If a currency

is freely convertible and traded in an active market, the spot rate reflects the market’s

best estimate of future events that will affect that currency. Therefore, the only

available unbiased estimate of a future exchange rate is the current spot rate, adjusted

by the difference in expected future rates of general inflation in the two currencies.

A present value calculation already deals with the effect of general inflation, since it

is calculated by estimating future cash flows in either nominal terms (i.e., including

the effect of general inflation and specific price changes) and discounting them at a

rate that includes the effects of general inflation; or real terms (i.e., excluding the

effect of general inflation but including the effect of specific price changes) and

discounting them at a rate that excludes the effect of general inflation.

Using a forward rate to translate present value expressed in a foreign currency would

count part of the time value of money twice (first in the discount rate and then again

in the forward rate). This is because a forward rate reflects the market’s adjustment

for the differential in interest rates. In some cases, a currency is not freely convertible

or is not traded in an active market. In consequence, it can no longer be assumed that

the spot exchange rate reflects the market’s best estimate of future events that will

affect that currency. Nevertheless, even in such cases, IAS 36 indicates that an

enterprise uses the spot exchange rate at the balance sheet date to translate value in

use estimated in a foreign currency. The argument for this approach is that it is

unlikely that an enterprise can make a more reliable estimate of future exchange rates

than the current spot exchange rate, adjusted by the difference in expected future rates

of general inflation in the two currencies.



66

An alternative to estimating the future cash flows in the currency in which they are

generated would be to estimate them in another currency as a proxy and discount

them at a rate appropriate for this other currency. This solution may be simpler,

particularly where cash flows are generated in the currency of a hyperinflationary

economy (in such cases, some would prefer using a hard currency as a proxy) or in a

currency other than the currency that an enterprise uses for measuring items in its

financial statements (the measurement currency). However, this solution may be

misleading if the exchange rate varies for reasons other than changes in the

differential between the general inflation rates in the two countries to which the

currencies belong. In addition, this solution is inconsistent with the approach under

IAS 29, Financial Reporting in Hyperinflationary Economies. If the appropriate

measurement currency is the currency of a hyperinflationary economy, IAS 29 does

not allow translation into a hard currency as a proxy for restatement in terms of the

measuring unit current at the balance sheet date. This is confirmed by SIC-19,

Reporting Currency - Measurement and Presentation of Financial Statements under

IAS 21 and IAS 29.

Chapter 7: Hedging InstrumentsNew International Accounting Standard of Insurance Industry


67

7.0 Hedging Instruments

7.1 Qualifying Instruments

IAS39 does not restrict the circumstances in which a derivative may be chosen as a

hedging instrument. Sometimes, a non-derivative financial asset or non-derivative

financial liability may be designated as a hedging instrument only for a hedge of a

foreign currency risk. Because there is a different measure standard for derivatives

and non-derivatives.

The potential loss on an option an entity writes could be significant greater than the

potential gain in value of a related hedged item. In other words, a written option is

ineffective in reducing the exposure on profit or loss. Hence, a designated as an offset

to a purchased option, including one that is embedded in another financial instrument

unless it is designated as an offset to a purchased option, including one that is

embedded in another financial instrument. For example, a written call option used to

hedge a callable liability. In contrast, a purchased option has potential gains equal to

or greater than losses and therefore has the potential to reduce profit or loss exposure

from changes in fair values or cash flows. Accordingly, it can qualify as a hedging

instrument.

An investment in an unquoted equity instrument that is not carried at fair value

because its fair value cannot be reliably measured or a derivative that is linked to and

must be settled by delivery of such an unquoted equity instrument cannot be

designated as a hedging instrument. If an entity's own equity securities are not

financial assets or financial liabilities of the entity and, therefore, cannot be

designated as hedging instruments.

7.1.1 Designation of Hedging Instruments

There is normally a single fair value measure for a hedging instrument in its entirety,

and the factors that cause changes in fair value are co-dependent. Thus, a hedging

relationship is chosen by an entity for a hedging instrument in its entirety. Separating

the intrinsic value and the time value of an option and designating only the change in

the intrinsic value of an option as the hedging instrument, and excluding the

remaining component of the option (its time value) and separating the interest element



68

and the spot price on a forward are the only exceptions permitted. Generally, the

intrinsic value of the option and the premium on the forward can be measured

separately. Therefore, a dynamic hedging strategy that assesses both the intrinsic

value and the time value of an option can qualify for hedge accounting.

A single hedging instrument may be called as a hedge of more than one type of risk

provided that the risks hedged can be identified clearly, the effectiveness of the hedge

can be established and there is possibly to ensure the specific designation of the

hedging instrument and different risk positions.

Sometimes, two or more derivatives may be viewed in combination and jointly

designated as the hedging instrument. However, an interest rate hedging or other

derivative instrument that combines a written option component and a purchased

option component does not qualify as a hedging instrument if it is, in effect, a net

written option.

A hedged item can be a recognised asset or liability, an unrecognised firm

commitment, or an uncommitted but highly probable anticipated future transaction

(forecast transaction), or a net investment in a foreign operation. Unlike originated

loans and receivables, a held-to-maturity investment cannot be a hedged item with

respect to interest-rate risk or prepayment risk because designation of an investment

as held-to-maturity requires an intention to hold the investment until maturity without

regard to changes in the fair value or cash flows of such an investment attributable to

changes in interest rates. However, a held-to-maturity investment can be a hedged

item with respect to risk from changes in foreign currency exchange rates and credit

risk.

A firm commitment to acquire a business in a business combination cannot be a

hedged item, except for foreign exchange risk because the other risks being hedged

cannot be specifically an identified measured. It is only a hedge of a general business

risk.

An equity method investment cannot be a hedged item in a fair value hedge because

the equity method recognises in profit or loss the investor's share of the associate's



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accrued profit or loss, rather than fair value changes. For a similar reason, an

investment in a consolidated subsidiary cannot be a hedged item in a fair value hedge

because consolidation recognises the parent's share of the subsidiary's loss. A hedge

of a net investment in a foreign operation is different because it is a hedge of the

foreign currency exposure, not a fair value hedge of the change in the value of the

investment.

7.1.2 Designation of Financial Items as Hedged items

A financial asset or financial liability maybe a hedged item with respect to the risks

associated with only a portion of its cash flows or fair value (such as one or more

selected contractual cash flows or portions thereof a percentage of the fair value),

provided that effectiveness can be measured. For example, an identifiable and

separately measurable portion of the interest rate exposure of an interest-bearing asset

or interest-bearing liability may be designated as the hedged risk (such as a risk-free

interest rate or benchmark interest rate component of the total interest rate exposure of

a hedged financial instrument.)

7.1.3 Designation of Non-Financial Items as hedged items

If a hedged item is a non-financial asset or non-financial liability either for foreign

currency risks or in its entirety for all risks, then it shall be designated as a hedged

item, because of the difficulty of isolating and measuring the appropriate portion of

the cash flows or fair value changes attributable to specific risks other than foreign

currency risks.

Because changes in the price of an ingredient of component of a non-financial asset or

non-financial liability generally do not have a predictable, separately measurable

effect on the price of the item that is comparable to the effect of a non-financial asset

or non-financial liability is a hedged item only in its entirety.

7.2 Hedge Accounting

For hedge accounting purposes, only derivatives that involve a party external to the

entity can be designated as hedging instruments. Although individual entities within a

consolidated group or divisions within an entity may enter into hedging transactions



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with other entities, any gains and losses on such transactions are eliminated on

consolidation. Therefore, such intra-group or intra-entity hedging transactions do not

qualify for hedge accounting in consolidation.

Hedge accounting recognises the offsetting effects on profit or loss of changes in the

fair values of the hedging instrument and the hedged item. Hedging relationships are

of three types:

a) fair value hedge: a hedge of exposure to changes in fair value of a recognised asset

or liability or a previously unrecognised firm commitment to buy or sell an asset at a

fixed price, or an identified portion of such an asset, liability or firm commitment, that

is attributable to a particular risk and could affect reported profit or loss. An example

of a fair value hedge is a hedge of exposure to changes in the fair value of fixed rate

debt as a result of changes in interest rates. Such a hedge could be entered into either

by the issuer or by the holder.

b) cash flow hedge: a hedge of the exposure to variability in cash flows that a) is

attributable to a particular risk associated with a recognised asset or liability (such as

all or some future interest payments on variable rate debt) or a forecast transaction

(such as an anticipated purchase or sale) and b) could affect report profit or loss. An

example of a cash flow hedge is use of a swap to change floating rate debt to fixed

rate debt (i.e. a hedge of a future transaction; the future cash flows being hedged are

the future interest payments.)

c) hedge of a net investment in a foreign operation as defined in IAS21. A hedge of a

firm commitment (for example, a hedge of the foreign currency risk in an

unrecognised contractual commitment by an airline to purchase an aircraft for a fixed

amount of a foreign currency or a hedge of the change in fuel price relating to an

unrecognised contractual commitment by an electric utility to purchase fuel at a fixed

price), is a hedge of an exposure to a change in fair value. Accordingly, such a hedge

is accounted for as a fair value hedge. When a previously unrecognised firm

commitment is designated as a hedged item, the subsequent cumulative change in the

fair value of the firm commitment attributable to the hedged risk is recognised as an



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asset or liability and changes in the fair value attributable to the hedged risk are

recognised in profit or loss.

If all the following conditions are met a hedging relationship can only qualify for

hedge accounting under this Standard:

a) at the inception of the hedge there is formal documentation of the hedging

relationship and the entity's risk management objective and strategy for undertaking

the hedge. That documentation shall include identification of the hedging instrument,

the related hedged item or transaction, the nature of the risk being hedged, and how

the entity will assess the hedging instrument's effectiveness in offsetting the exposure

to changes in the hedged item's fair value or the hedged transaction's cash flows that is

attributable to the hedged risk

b) the hedge is expected to be highly effective in achieving offsetting changes in fair

value or cash flows attributable to the hedged risk, consistently with the originally

documented risk management strategy for that particular hedging relationship

c) for cash flow hedges, a forecast transaction that is the subject of the hedge must be

highly probable and must present an exposure to variations in cash flows that could

ultimately affect reported profit or loss

d) the effectiveness of the hedge can be reliably measured, i.e. the fair value or cash

flows of the hedged item and the fair value of the hedging instrument can be reliably

measured

e) the hedge is assessed on an ongoing basis and determined actually to have been

highly effective throughout the financial reporting period.

7.2.1 Assessing hedge effectiveness

A hedge is normally regarded as highly effective if, at inception and throughout the

life of the hedge, the entity can expect changes in the fair value or cash flows of the

hedged item to be almost fully offset by the changes in the fair value or cash flows of

the hedging instrument, and actual results are within a range of 80 percent to 125

percent. For example, if the loss on the hedging instrument is 120 and the gain on the

cash instrument is 100, offset can be measured by 120/100, which is 120 percent, or

by 100/120, which is 83 percent. In this example, the entity would conclude that the

hedge is highly effective.



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The method an entity adopts for assessing hedge effectiveness depends on its risk

management strategy. In some cases, an entity adopts different methods for different

types of hedges. If the principal terms of the hedging instrument and of the hedged

asset or liability or hedged forecast transaction are the same, the changes in fair value

and cash flows attributable to the risk being hedged may be likely to offset each other

fully, both when the hedge is entered into the thereafter. For instance, an interest rate

swap is likely to be an effective hedge if the notional and principal amounts, term,

repricing dates, dates of interest and principal receipts and payments, and basis for

measuring interest rates are the same for the hedging instrument and the hedged item.

On the other hand, sometimes the hedging instrument offset the hedged risk only

partially. For instance, a hedge would not be fully effective if the hedging instrument

and hedged item are denominated in different currencies that do not move in tandem.

Also, a hedge of interest rate risk using a derivative would not be fully effective if

part of the change in the fair value of the derivative is attributable cannot be measured

because those risks are not measurable reliably.

To qualify for hedge accounting, the hedge must relate to a specific identified and

designated risk, and not merely to overall business risks, and must ultimately affect

the entity's profit or loss. A hedge of the risk of obsolescence of a physical asset or

the risk of expropriation of property by a government would not be eligible for hedge

accounting; effectiveness cannot be measured because those risks are not measurable

reliably.

In the case of interest rate risk, hedge effectiveness maybe assessed by preparing a

maturity schedule for financial assets and financial liabilities that shows the net

interest rate exposure for each time period, provided that the net exposure associated

with a specific asset or liability (or a specific group of assets or liabilities or a specific

portion thereof) giving rise to the net exposure and hedge effectiveness is assessed

against that asset or liability.

This Standard does not specify a single method for assessing hedge effectiveness. An

entity's documentation of its hedging strategy includes its procedures for assessing



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effectiveness. Those procedures state whether the assessment included all of the gain

or loss on a hedging instrument or whether the instrument's time value is excluded.

Effectiveness is assessed, at a minimum, at the time an entity prepares its annual or

interim financial statements. If the critical terms of the hedging instrument and the

entire hedged asset or liability or hedged forecast transaction are the same, an entity

could conclude that changes in fair value or cash flows attributable to the risk being

hedged are expected to offset each other fully at inception and on an ongoing basis.

For example, an entity may assume that a hedge of a forecast purchase of a

commodity with a forward contract will be highly effective and that there will be no

ineffectiveness to be recognised in profit or loss if:

a) the forward contract is for the purchase of the same quantity of the same

commodity at the same time and location as the hedged forecast purchase

b) the fair value of the forward contract at inception is zero

c) either the change in the discount or premium on the forward contract is excluded

from the assessment of effectiveness and included directly in profit or loss or the

change in expected cash flows on the forecast transaction is based on the forward

price for the commodity

In assessing the effectiveness of a hedge, an entity generally consider the time value

of money. The fixed interest rate on a hedged item need not exactly match the fixed

interest rate on a swap designated as a fair value hedge. Nor does the variable interest

rate on an interest-bearing asset or liability need to be the same as the variable interest

rate on a swap designated as a cash flow hedge. A swap's fair value derives from its

net settlements. The fixed and variable rates on a swap can be changed without

affecting the net settlement if both are changed by the same amount.

7.2.2 Fair Value Hedges

If a fair value hedge meets the conditions as mentioned before, it shall be accounted

for as follows:

a) the gain or loss from remeasuring the hedging instrument at fair value (for a

derivative hedging instrument) or the foreign currency component of its carrying

amount (for a non-derivative hedging instrument) shall be recognised immediately in

profit or loss; and



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b) the gain or loss on the hedged item attributable to the hedged risk shall adjust the

carrying amount of the hedged item and be recognised immediately in profit or loss.

This applies even if a hedged item is otherwise measured at fair value with changes in

fair value recognised directly in equity. It also applies if the hedged item is otherwise

measured at cost.

If only particular risks attributable to a hedged item have been hedged, recognised

changes in the fair value of the hedged item unrelated to the hedge are recognised in

one of the two ways. An entity shall discontinue prospectively the hedge accounting if

it is regarded as an expiration or termination if such replacement or rollover is part of

the entity's documented hedging strategy or the hedge no longer meets the criteria for

hedge accounting

An adjustment to the carrying amount of a hedged interest-bearing financial

instrument shall be amortised to profit or loss. Amortisation may begin no later than

when the hedged item ceases to be adjusted for changes in its fair value attributable to

the risk being hedged. The adjustment is based on a recalculated effective interest

rate at the date amortisation begins and shall be amortised fully by maturity.

7.2.3 Cash Flow Hedges

If a cash flow hedge meets the condition during financial reporting period, it shall be

accounted for as follows:

a) the portion of the gain or loss on the hedging instrument that is determined to be an

effective hedge shall be recognised directly in equity through the statement of changes

in equity; and

b) the ineffective portion of the gain or loss on the hedging instrument shall be

recognised:

i) immediately in profit or loss if the hedging instrument is a derivative; or

ii) in accordance with a recognised gain or loss arising from a change in the

fair value of a financial asset or financial liability (that is not part of a hedging

relationship shall be recognised as follows:

a) a gain or loss on a financial asset or financial liability held for trading

shall be recognised in profit or loss for the period in which it arises



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(in this regard, a derivative trading unless it is a designated hedging

instrument)

b) gain or loss on an available-for-sale financial asset shall be

recognised directly in equity, through the statement of changes in

equity, except for impairment losses, until the financial asset is

derecognised at which time the cumulative gain or loss previously

recognised in equity shall be recognised in profit or loss for the

period. However, the amortisation using the effective interest method

of any difference between the amounts recognised initially and the

maturity amount of an available-for-sale financial asset represents

interest and is recognised in profit or loss)

in the limited circumstances in which the hedging instrument is not a derivative

More specifically, a cash flow hedge is accounted for as follows:

a) the separate component of equity associated with the hedged item is adjusted to the

lesser of the following (in absolute amounts):

i) cumulative gain or loss on the hedging instrument and

ii) the cumulative change in fair value (present value) of the expected future cash

flows on the hedged item from inception of the hedge;

b) any remaining gain or loss on the hedging instrument (which is not an effective

hedge) is included in profit or loss or directly in equity

c) if an entity's documented risk management strategy for a particular hedging

relationship excludes a specific component of the gain or loss or related cash flows on

the hedging instrument from the assessment of hedge effectiveness that excluded

component of gain or loss is recognised.

If a hedge of a forecast transaction subsequently results in the recognition of an asset

or a liability, then the associated gains or losses that were recognised directly in

equity. It should be reclassified into profit or loss in the same period or periods

during which the asset acquired or liability incurred affects profit or loss (such as in

the periods that depreciation expense, interest expense, or cost of sales is recognised).

However, if an entity expects at any time that all or a portion of a net loss recognised

directly in equity will not be recovered in one or more future periods, it shall



76

reclassify immediately into profit or loss the amount that is not expected to be

recovered.

An entity shall discontinue prospectively the hedge accounting of the cash flow hedge

if any one of the following occurs:

a) the hedging instrument expires or is sold, terminated, or exercised (for this

purpose, the replacement or a rollover of a hedging instrument into

another hedging instrument is not regarded as an expiration or termination

if such replacement or rollover is part of the entity's documented hedging

strategy.) In this case, the cumulative gain or loss on the hedging

instrument that initially had been reported directly in equity when the

hedge was effective shall remain separately in equity until the forecast

transaction occurs.

b) the hedge no longer meets the criteria for hedge accounting as we

mentioned before. In this case, the cumulative gain or loss on the hedging

instrument that initially had been reported directly in equity when the

hedge was effective shall remain separately in equity until the forecast

transaction occurs.

c) the forecast transaction is no longer expected to occur, in which case any

related cumulative gain or loss that had been recognised directly in equity

shall be recognised in profit or loss for the period. A forecast transaction

that is no longer highly probable may still be expected to occur.

7.2.4 Net Investment Hedges

Hedges of a net investment in a foreign operation, including a hedge of a monetary

item that is accounted for as part of the net investment, shall be accounted for

similarly to cash flow hedges:

a) the portion of the gain or loss on the hedging instrument that is determined to

be an effective hedge shall be recognised directly in equity through the

statement of change in equity; and

b) the ineffective portion shall be recognised;

c) immediately in profit or loss if the hedging instrument is a derivatives



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The gain or loss on the hedging instrument relating to the effective portion of the

hedge that has been recognised directly in equity shall be recognised in profit or loss

at the disposal of the foreign operation.

If a hedge that do not qualify for hedge accounting because it fails to meet the criteria,

gains and losses arising from changes in the fair value of a hedged item that is

measured at fair value after initial recognition are recognised in one of the two ways

in a gain or loss on a financial asset or financial liability held for trading or gain or

loss on an available-for-sale financial asset. Fair value adjustments of a hedging

instrument that is a derivative would be recognised in profit or loss.

Chapter 8: ConclusionNew International Accounting Standard of Insurance Industry


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8.0 Conclusion

8.1 The over view of IAS

The former IASC Board started a project on Insurance Accounting in 1997. An

Insurance Steering Committee was set up and, in December 1999, they published an

Issues Paper on Insurance. The IASC received 138 comment letters in response to this

Issues Paper worldwide. The Steering Committee met in September 2000 and

November 2000 to review the comment letters and to develop a report to the former

IASC Board in the form of a first draft of a Draft Statement of Principles (DSOP).

In April 2001, a new International Accounting Standards Board was appointed

(IASB), to replace the former IASC Board. The new Board decided to allow the

Insurance Steering Committee to complete its work on the Insurance DSOP. In June

2001, the Insurance Steering Committee met in Paris and discussed the last draft of

the DSOP, which they aim to finalise by October 2001 as a report to the IASB. At the

September 2001 IASB meeting, the IASB agreed to the Steering Committee’s

proposal to carry out field visits with insurance companies, to discuss practical issues

on the basis of the current proposals in the DSOP but did not otherwise discuss the

June 2001 draft DSOP.

In accordance with the IASC framework, the future standard on insurance contracts

will prescribe the accounting and disclosure in general financial statements by

insurers and policyholders for all insurance contracts, regardless of the industry of the

enterprise concerned. The assets and liabilities of an insurance company not directly

linked to insurance contracts should be evaluated and accounted for in accordance

with other relevant standards (e.g., IAS 39, Financial Instrument: Recognition and

Measurement, for financial assets and liabilities, IAS 40, Investment Property, for

investment property).

As a consequence, a significant part of the assets could be measured at fair value. As

it is sometimes difficult to distinguish an insurance contract from other financial

instruments, it is important to define what an insurance contract is and to highlight the

principal elements of differentiation. An insurance contract would be defined as “a



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contract under which one party (the insurer) accepts an insurance risk by agreeing

with another party (the policyholder) to compensate the policyholder or other

beneficiary if a specified uncertain future event adversely affects the policyholder or

other beneficiary (other than an event that is only a change in one or more of a

specified interest rate, security price, commodity price, foreign exchange rate, index

of prices or rates, a credit rating or credit index or similar variable)”. The new

definition includes the notion of “uncertain future event”. That is, it is uncertain at the

inception of a contract whether:

• a future event specified in the contract will occur,

• when the specified event will occur, and

• how much the insurer will need to pay if the specified future event occurs.

This definition should result in the classification of, and accounting for, some

insurance products as financial instruments (especially a great majority of saving-

oriented products). As there should be a single definition of an insurance contract,

there should be a single recognition and measurement approach for all forms of

insurance contracts, and as a consequence for the insurance assets and liabilities,

regardless of the type of risk underwritten (i.e., life insurance or non-life insurance).

That approach would be an “Asset and Liability” measurement approach rather than

the traditional “Deferral and Matching” measurement approach. The “Deferral and

Matching” approach is the most common approach applied today, under which

revenues and expenses are deferred and matched accordingly.

Within this context and following the Joint Working Group (JWG) proposals,

insurance assets and liabilities should be measured on a prospective basis, reflecting

the present value of all future cash flows arising from the closed book of insurance

contracts in existence at reporting date. Two methods of prospective measurement

could be considered:

• fair-value, and

• entity-specific value.

The first method, fair value, is the amount for which an asset could be exchanged or a

liability settled between knowledgeable, willing parties in an arm’s length transaction.

This corresponds to an exchange value. The second method, entity-specific value,



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represents the value of an asset or a liability to the enterprise that holds it, and may

reflect factors that are not available (or not relevant) to other market participants. This

corresponds to a “value in use”. Whatever the final measurement approach might be,

it should reflect risk and uncertainty either in the discount rate or in the amount of

cash flows. The June 2001 draft DSOP is currently leaning towards a “stochastic

method” to estimating future cash flows. The stochastic approach captures the full

range of possible outcomes and the shape of their probability distribution, in

comparison with a “deterministic approach”, which has no ready means of capturing

correlation between cash flows and interest rates. The June 2001 draft DSOP

expresses the view that the value of an insurance contract should be independent of

the investing strategy of an enterprise. Consequently, the insurance liabilities should

not be affected by the type, or by the yield, of the financial assets held by an

enterprise.

Within this context, insurance liabilities should be linked to risk-free rates and not to

the yield of the financial assets. A different approach should nevertheless be used for

some specific insurance contracts such as unit-linked and participating contracts. The

future Standard would introduce some major changes in the current measurement and

financial reporting for insurance contracts: variations in the present value would be

reflected in the income statement, present value of some part of the future margins

would be recognised in the income statement at inception (the amount taken will

depend on certain variables), some technical reserves that would not meet the

definition of a liability would not be recognized (such as unearned premiums or

equalisation reserves).

Nevertheless, no final decisions have yet been made. The new IASC Board, the IASB,

had planned to study the June 2001 draft DSOP for the first time during the meeting

that took place on 13 September 2001. This discussion was subsequently cancelled

and has been postponed to the October 2001 IASB meeting. Before resolving the key

issues raised by the June 2001 draft DSOP, the Board will probably attempt to define

clearly what the overall objectives of financial reporting should be.



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8.2 Insurance Contracts

The objective of the IAS board should in a neutral position, however, the funding of

the IAS board mostly come from the US accounting firm. Although, there are

different countries’ members in the committee in order to receive a lot of different

countries’ accounting opinion, there is always an argument that the IAS are very

favour to the US standard. That is the main reason why there are many European

companies standing up and oppose about the 2005 acts. European companies have

their own traditional system; if they need to follow the IAS they will need to change

their whole accounting structure eventually. But not the US companies, because they

are used to work on something very similar.

The Steering Committee’s decision to focus on insurance contracts is better rather

than to focus on insurance enterprises. To ensure fair, comparable and equitable

treatment across industry lines, the ultimate accounting principles developed should

not be dictated by the nature nor the legal form of a company but rather the economic

characteristics of the product sold and the risks assumed. In recent years the financial

services industry has changed greatly and insurers now find themselves competing

with other financial service providers on similar financial products. An accounting

standard should not penalise insurance companies relative to the others by creating

“arbitrage” opportunities to the insurance industry’s disadvantage. Equally as

important is the underlying conceptual consistency of the accounting standards within

our industry. Insurance companies sell a broad spectrum of products with varying

economics features and degrees of risk. While the accounting principles for all

products sold by insurance companies should not be identical, the accounting

principles employed should be based on the same fundamental underlying foundation.

The use of a substantively different accounting model for products that cross a

subjective line, i.e. significant insurance or mortality risks, would be inconsistent with

the principle of comparability between industries and products.

The definition of insurance contracts should be broadened in order to cover a

comprehensive variety of products sold by insurance companies and as permitted by

regulators, at the moment and in the future. Furthermore, insurance contracts should

not be unbundled for the different components therein, particularly life contracts. This



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view is based on the premise that insurance risk and investment aspects are closely

linked together. To separate the various components of insurance contract would be

artificial and misleading, and the comparability would be difficult because the

subjectivity of the unbundling criteria is unavoidable.

Using the IASC Framework as a basis for building an insurance accounting standard

will help to achieve consistency between insurers and other enterprises. The asset and

liability approach, which has the favour of the Steering Committee, is consistent with

the Framework. But the asset and liability approach needs to be amended by the

deferral and matching approach. As for other industries, which use some deferral

mechanisms, insurance performance reporting needs to take into consideration in a

dynamic way the features of the insurance service rendered over policy lives.

Financial information provided to investors should be compatible with that used by

management of the company to assess operational performance and to make strategic

decisions. The main objective is to ensure that the financial statements are

economically sound, i.e., accurately reflect an insurance enterprise’s creation of value

and its financial position. As for other service industries, the overall profitability can

only be determined after all obligations out of the contracts have been met. Another

unique aspect of insurance is its combination of individual contracts and pooling of

risks into portfolios, thereby diversifying risk. The outcome of a portfolio can be

predicted much more reliably than the outcome of individual contracts. Therefore, we

believe that the ultimate model proposed should emphasize a portfolio-based

approach as opposed to an individual contract approach.

In particular, the life insurance and general insurance accounting should focus on the

renewal rights, the right to receive future premiums and the policyholder’s right to

cancel the contract. It is important to establish whether the assets or liabilities meet

the definitions contained in the IASC framework in order to recognise them in the

balance sheet. The principle in accounting for policy, whether life or general, with a

duration of more than one year, all expected cash flows for the remaining period of

the contract should be taken into account in valuing the liability.



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8.3 The Fair Value Debate

There is strong momentum at the IASC toward measuring all financial instruments at

their fair value. The fair value concept is difficult to apply particularly to insurance

contracts because transactions by which to judge fair values are confined to relatively

infrequent acquisitions of insurance companies or insurance portfolios. Even in such

transactions, acquisition costs cannot be considered as an absolute fair value because

they depend on the judgment of the buyer and its overall interest in the deal.

For insurance contracts, fair value cannot be a market value but a constructed value

using expected future cash flows and present value techniques, and generated from an

assessment of the entire portfolio-in-force using management data with some

parameters driven by the market. A fair value approach for accounting for insurance

liabilities should be rejected since there is no active market for insurance contracts,

the valuation of insurance contracts could be only an estimation and it would

introduce volatility in earnings due to the judgmental aspects in assumptions to be

made in the fair value of liabilities since the insurance markets, which are specifically

regulated, rely on the assumption that liabilities to policyholders will be met.

While financial markets are volatile, effective asset-liability management prevents

such volatility from impairing an insurer’s ability to fulfil its promises. If the new

accounting standards fail to reflect accurately the compensating effects of an insurer’s

asset-liability management, what insurers consider “fictitious” volatility will emerge

and the accounting standards will quickly lose credibility. While it is difficult to be

judgmental when the concept of fair value of an insurance contract is yet to be

defined, an accounting model whereby all changes in fair value are recorded in

income will produce such “fictitious” volatility.

The fair value cannot mean pure market value. This is because from a practical point

of view a narrower interpretation (which considers the two value measurements as

interchangeable) would be untenable where there is no active market for the asset or

liability in question. This would be a particular problem in relation to insurance

liabilities. However, rather than concluding from this that a fair value approach would

be inappropriate, the IASC should continue to recognise that there are other methods



84

for measuring fair value. The methods adopted must be sufficiently well defined and

tested to provide assurance that measurement will be implemented on a consistent

basis. Achievement of this objective will result in the provision of more relevant and

subjective information to users than would be available to them under alternative

bases of accounting.

Asset-liability management, which must be based on long-term duration according to

the life of the contracts, cannot be accurately measured by short-term measurements

like fair values. For example, insurance companies prudently invest in equity

securities based on long-term perceptions of value that are unaffected by short-term

volatility. However, even though changes in the stocks markets could cause dramatic

volatility, most insurance contract fair values (other than certain life insurance

contracts, i.e., participating and unit-linked) will likely be unaffected by these market

movements. Despite such shortfalls, the fair value model provides key information to

investors. But reporting changes in the fair value of investments owned by insurance

companies (financial assets, i.e., equities or fixed maturities, as well as real estate) and

insurance liabilities in the income statement would be generally unacceptable. The

reasons are:

(i) those assets and liabilities are not held for trading purpose

(ii) the lack of well tried and harmonized methodologies to estimate the fair

value of insurance liabilities

(iii) a fair value basis accounting would introduce a rather fictitious volatility

into the financial statements

This fictitious volatility leads to a higher cost of capital putting insurance companies

at a disadvantage compared to other industries. With respect to the insurance contracts

and other instruments non traded on active market, fair value is a subjective concept

and debates are sure to ensue not only when defining the concept, but also when

applying it in practice. As well, the introduction of such a subjective notion would

jeopardize the comparability with other industries, which is one of the aims of the

accounting standardisation. When and if a full fair value model is adopted for all

activities (including insurance), we consider that a (long) transition period should be

necessary as a testing phase for preparers and auditors and as an educational phase for

users. Only a later step would have the balance sheet on a fair value basis and



85

changes in fair value directly in equity (with specific consideration relating to

participating life policies earnings, which would be better presented in income

statement). In any case, net income should be presented by separating the adjustments

of fair value from the other operating components.

Instead, if the accounting for insurance contracts is to go down the fair value route it

would seem preferable to define fair value of liabilities according to a set of principles

discussed and agreed between the accounting and actuarial professions. It is suggested

possible principles could be as follows: -

(1) Assets and liabilities should be valued on a consistent basis,

(2) The rates of interest used for discounting should take into account prevailing

financial conditions. For example, if assets are available to hedge the liabilities

then the current yield on these assets should be used,

(3) The expected present value of the future payments (less future premiums)

under the insurance contract should be calculated using the company’s own

best estimate of its likely future experience. This would apply to expenses,

mortality, morbidity, longevity, lapses etc. The company should use the best

available econometric market data (e.g. for inflation) and demographic data

(e.g. for mortality, morbidity, rate of improvement of longevity) but the value

would not be based on some perceived ‘market rate’ for expenses, mortality or

morbidity since

(a) a market does not exist and

(b) it is appropriate to measure the profitability of the company concerned

and not some hypothetical ‘market’ company,

(4) It should be permitted to increase the expected present value as calculated by a

‘risk margin’ to allow for two economic facts

(a) even if the econometric and demographic parameters were correctly

estimated the payments never work out exactly as expected and

payments could be more or less depending on the actual state of the

world which transpires (i.e. there is statistical variation about the

mean) and

(b) it is not possible to estimate the value of the econometric and

demographic parameters with certainty. In addition it should be

permissible to add a shareholder ‘profit margin’ to the above value in



86

order to avoid an emergence of profit at the point of sale, which was

not acceptable to the accounting bodies in the country concerned. The

flexibility to include such a profit margin should facilitate the

alignment of the accounting treatment of insurance and investment

contracts,

(5) Indirect methods equivalent to the above should also be acceptable

(6) If a company was not using an embedded value method to determine profits

and balance sheet totals, the company should be permitted to publish an

embedded value each year as a note to the Accounts. The above principles

would seem to be contained within the ‘Discounting Issues Paper’ produced

by the IASC Discounting Steering Committee. It is a desirable aim that the

principles for discounting cash flows are uniform across the range of

accountancy applications.

8.4 Insurance Policy

The principle in accounting for a policy, whether life or general, with a duration of

more than one year, all expected cash flows for the remaining period of the contract

should be taken into account in valuing the liability. However, in respect to

recognition of profit at inception of a contract, the Steering Committee needs to

consider whether the recognition of profit arising from cash flows in periods covered

by future renewal premiums is consistent with the principles on the recognition of

contingent assets in IAS 37 and the surrender value floor for life insurance business. It

is not appropriate to take profits at inception on such long term general insurance

contracts as there is normally a contractual obligation for the policyholder to pay

future premiums, but this is not an enforceable obligation as the policyholder can

cancel the policy.

The asset or liability model provides a good starting point for developing accounting

standards. This does not preclude the incorporation of the technique of accrual and

deferral accounting where these techniques may help in measuring a meaningful

figure of income from operations for a period. The IASC needs to ensure that there is

no inconsistency between the requirements of the insurance standard, IAS 1 (accruals

and matching concept) and the principles of revenue recognition in IAS 18. It may



87

possible to develop a set of principles to apply the asset or liability model, which

recognises some of the earning process principles, included in other IASC standards.

8.4.1 Life Insurance

The conclusion reached by the Steering Committee and the prospective approach to

the valuation of liabilities is supported. But they have the following observations

under and asset or liability model:

a) The conclusion that the insurance contract as a whole can result in the

recognition of a net asset arising from future cash flows are nor agreed. The

net asset arises in cases where future premiums exceed claims and expenses. If

the Steering Committee has decided that future premiums cannot be

recognized as an asset because the insurer does not have control, it is therefore

inappropriate to recognise the asset.

b) It is not clear whether the surrender value floor is applied on a contract-by-

contract basis or a portfolio basis. Therefore the portfolio approach should be

adopted.

c) In certain circumstances, particularly where a company has incurred high

front-end acquisition costs, the proposed asset and liability approach will lead

to the recognition of losses in the early years of the contract. It is clearly

undesirable to report losses on contracts that are expected to be profitable.

--END--

AppendixNew International Accounting Standard of Insurance Industry


88

APPENDICES



89

Appendix A1

The disclosures required by IAS 39 are:

The following should be included in the disclosures of the enterprise’s accounting

policies as part of the disclosure required by IAS 32:

(a) the methods and significant assumptions applied in estimating fair values of

financial assets and financial liabilities that are carried at fair value, separately for

significant classes of financial assets;

(b) whether gains and losses arising from changes in the fair value of those financial

assets and financial liabilities that are measured at fair value subsequent to initial

recognition, other than those held for trading, are included in net profit or loss for the

period or are recognised directly in equity until the financial asset is disposed of or the

liability is extinguished; and

(c) for each of the four categories of financial assets defined, whether ‘regular way’

purchases of financial assets are accounted for at trade date or settlement date.

In applying paragraph 167(a), disclosure would include prepayment rates, rates of

estimated credit losses, and interest or discount rates.

Financial statements should include all of the following additional disclosures relating

to hedging:

(a) describe the enterprise’s financial risk management objectives and policies,

including its policy for hedging each major type of forecasted transaction;

For example, in the case of hedges of risks relating to future sales, that description

indicates the nature of the risks being hedged, approximately how many months or

years of expected future sales have been hedged, and the approximate percentage of

sales in those future months or years;

(b) disclose the following separately for designated fair value hedges, cash flow

hedges, and hedges of a net investment in a foreign entity:

(i) a description of the hedge;

(ii) a description of the financial instruments designated as hedging instruments for

the hedge and their fair values at the balance sheet date;

(iii) the nature of the risks being hedged; and



90

(iv) for hedges of forecasted transactions, the periods in which the forecasted

transactions are expected to occur, when they are expected to enter into the

determination of net profit or loss, and a description of any forecasted transaction for

which hedge accounting had previously been used but that is no longer expected to

occur; and

(c) if a gain or loss on derivative and non-derivative financial assets and liabilities

designated as hedging instruments in cash flow hedges has been recognised directly in

equity, through the statement of changes in equity, disclose:

(i) the amount that was so recognised in equity during the current period;

(ii) the amount that was removed from equity and reported in net profit or loss for the

period; and

(iii) the amount that was removed from equity and added to the initial measurement of

the acquisition cost or other carrying amount of the asset or liability in a hedged

forecasted transaction during the current period.

Financial statements should include all of the following additional disclosures relating

to financial instruments:

(a) if a gain or loss from remeasuring available-for-sale financial assets to fair value

(other than assets relating to hedges) has been recognised directly in equity, through

the statement of changes in equity, disclose:

(i) the amount that was so recognised in equity during the current period; and

(ii) the amount that was removed from equity and reported in net profit or loss for the

period;

(b) if the presumption that fair value can be reliably measured for all financial assets

that are available for sale or held for trading has been overcome and the enterprise is,

therefore, measuring any such financial assets at amortised cost, disclose that fact

together with a description of the financial assets, their carrying amount, an

explanation of why fair value cannot be reliably measured, and, if possible, the range

of estimates within which fair value is highly likely to lie. Further, if financial assets

whose fair value previously could not be measured reliably are sold, that fact, the

carrying amount of such financial assets at the time of sale, and the amount of gain or

loss recognised should be disclosed;



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(c) disclose significant items of income, expense, and gains and losses resulting from

financial assets and financial liabilities, whether included in net profit or loss or as a

separate component of equity.

For this purpose:

(i) total interest income and total interest expense (both on a historical cost basis)

should be disclosed separately;

(ii) with respect to available-for-sale financial assets that are adjusted to fair value

after initial acquisition, total gains and losses from derecognition of such financial

assets included in net profit or loss for the period should be reported separately from

total gains and losses from fair value adjustments of recognised assets and liabilities

included in net profit or loss for the period (a similar split of ‘realised’ versus

‘unrealised’ gains and losses with respect to financial assets and liabilities held for

trading is not required);

(iii) the enterprise should disclose the amount of interest income that has been accrued

on impaired loans and that has not yet been received in cash;

(d) if the enterprise has entered into a securitisation or repurchase agreement, disclose,

separately for such transactions occurring in the current financial reporting period and

for remaining retained interests from transactions occurring in prior financial

reporting periods:

(i) the nature and extent of such transactions, including a description of any collateral

and quantitative information about the key assumptions used in calculating the fair

values of new and retained interests;

(ii) whether the financial assets have been derecognised;

(e) if the enterprise has reclassified a financial asset as one required to be reported at

amortised cost rather than at fair value, disclose the reason for that reclassification;

and

(f) disclose the nature and amount of any impairment loss or reversal of an

impairment loss recognised for a financial asset, separately for each significant class

of financial asset.



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Appendix E1

The simplest form of prospective life insurance model builds on the assumptions just

described to compute the present values of individual inflows and outflows, as shown

below.

Projected asset earning rate 7.00%

Present value of gross premiums 92,882 100.00%

Present value of death & surrender benefits (55,049) -59.27%

Present value of costs & expenses (21,228) -22.85%

Present value of net income 16,605 17.88%

Appendix E1 – Prospective Computations

Appendix E2

The amounts derived in Appendix E1 are then applied to compute a liability for

policyholder benefits, as shown below. This approach is familiar to most accountants and

actuaries refer to this computation as a retrospective computation of the liability.

dr. (cr.)

Year 1 Year2

Premiums received 14,000 11,194

Beginning balance - (8,458)

Addition to liability -59.27% of premiums (8,298) (6,635)

(8,298) (15,093)

Interest at 7.00% (581) (1,057)

Benefits paid Surrenders - 716

Deaths 400 400

Processing 21 10

Ending balance (to balance sheet) (8,458) (15,024)

Appendix E2 – Benefit Computation



93

Appendix E3

Alternatively, the liability can be computed using the approach below and this approach

is perhaps more familiar to most actuaries.

dr. (cr.)

Year 1 Year 2

Present value of remaining premiums 84,404 78,334

Times percentage needed to fund benefits 59.27% 59.27%

50,026 46,429

Present value of remaining benefits (58,482) (61,449)

Liability balance (8,456) (15,020)

Appendix E3 – Benefit Computation

Appendix E4

If the insurer recognises acquisition costs as an asset, the same techniques can be used to

amortise that asset over the life of the book, as shown below:

dr. (cr.)

Year 1 Year 2

Premiums received 14,000 11,194

Beginning balance - 9,713

Costs incurred Commissions 7,000 560

Other 1st year 4,388 -

Recurring expenses 889 711

Amortisation -22.85% of premiums (3,199) (2,558)

9,078 8,426

Interest at 7.00% 635 590

Ending balance (to balance sheet) 9,713 9,016

Appendix E4 – Amortisation of Acquisition Costs



94

Appendix E5

Appendix E5 shows the computation of the benefit liability using a policyholder-deposit

method.

dr. (cr.)

Year 1 Year 2

Beginning balance - (8,391)

Premiums received (14,000) (11,194)

Amounts assessed against policyholders

Mortality charges 1,730 1,504

Contract maintenance 2,370 1,895

(9,900) (16,186)

Interest at the credit rate of 6.00% (594) (971)

(10,494) (17,157)

Contract balances of policyholders

deceased during the period 4 9

Contract balances of policies

surrendered during the period 2,099 2,060

Ending balance (8,391) (15,088)

Appendix E5 – Policyholder Deposit Computations



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Appendix E6

A policyholder-deposit approach requires a different approach to amortising deferred

acquisition costs. Because the approach looks to contract margins as the source of

earnings, deferred acquisition costs are amortised based on present value of estimated

margins, as shown in Appendix E6 and E7.

Present value (at credited rate of 6%) of:

Charges for early surrender (4,862)

Mortality assessments (16,548)

Mortality benefits paid

in excess of contract balances 6,605

Contract maintenance assessments (15,831)

Recurring contract expenses 10,679

Investment income related to policy balances (59,556)

Interest credited to policyholders 51,048

Present value of gross profits (28,465)

Present value of capitalized acquisition costs 10,688

Amortisation costs -37.548%

Appendix E6 – Policyholder-deposit Approach,

Computation of Amortisation Factor



96

Appendix E7

dr. (cr.)

Year 1 Year 2

Beginning balance - 9,717

Nonrecurring costs incurred 10,688 -

10,688 9,717

Interest at 6.00% 641 583

(a) 11,329 10,300

Gross profits 4,292 3,233

times amortization factor -37.55% -37.55%

(b) 1,612 1,214

Ending balance, (a) + (b) 9,717 9,086

Appendix E7 – Policyholder-deposit Approach,

Amortisation of Deferred Acquisition Costs

ReferencesNew International Accounting Standard of Insurance Industry


97

References

1) The International Accounting Standards Board Draft Insurance Paper, (Chapter 2

- Overall Approach, Recognition and Derecognition), Page 3-8, 11-16-2001

2) Deloitte Touche Tohmatsu. (Future International Accounting Standard on

Insurance Contracts), Page 8-17,2001

3) Michel Abbink and Matt Saker, (Getting to grips with fair value), The Staple Inn

Actuarial Society, Page 7-56, 5-30-2002


- Overall view), Page 2-22, 11-16-2001

5) The International Accounting Standards Board Insurance Paper, (Introduction),

Page: 1-35, 2001

6) Basel Committee On Banking, (Report to G7 Finance Ministers and Central Bank

Governors on International Accounting Standards), Page 1-39, 4/2000

7) The International Accounting Standards Board Insurance Paper, (Fair Value

Issue), Page: 146-177, 2001

8) Casualty Actuarial Task Force on Fair Value Liabilities, (Cas Task Force on Fair

Value Liabilities White Paper on Fair Valuing Property/Casualty Insurance

Liabilities), Page 1-70, 2000

9) The International Accounting Standards Board Insurance Paper, (Fair Value

Issue, Appendix), Page: 1-37, 2001


– Estimating the Amount and Timing of Cash flows), Page 1-52, 12-07-2001

11) Peter Duran, Mark Freedman, and Emma McWilliam, (IAS: Some Pain, Much

Gain for Insurers), Ernst and Young, Page 1-4, 2001


– Discount rate), Page 1-7, 12-07-2001

13) The International Accounting Standards Board Draft Insurance Paper, (Chapter 2i

– Table of Overview of Different Approaches), Page 1-8, 12-07-2001

14) Investment Support Systems, Inc, (FAS 133 and IAS39 Derivative Hedge

Accounting), Page 1, 2002

ReferencesNew International Accounting Standard of Insurance Industry


98

15) D.O. Forfar, FFA, FSS, FIMA, CMath, Senior Lecturer in Actuarial Science,

Heriot-Watt University, Edinburgh. (Submission to Steering Committee on

Insurance of IASC, Comments on the issues Paper of Nov 1999), Page 1-11, 2000

16) The International Accounting Standards Board Comment Letter, Julian Hance,

Group Finance Director, Royal & Sun Sunalliance, (Insurance: An issues paper

issued for comment by the Steering Committee on Insurance), Page 1-9, 05-06-

2000

17) The International Accounting Standards Board Comment Letter, written together

by Aegon, Allianz, Assicurazion Generali, AXA, Fortis, ING groep, Munich

Reinsurance, Swiss Life, Swiss Re, (Observations on the Document: 'Insurance-

Issues paper' of the IASC), Page 1-15, 31-05-2000

18) The International Accounting Standards Board Comment Letter, D R Leighton,

Head of Legal & Fiscal Affairs Association of British Insurers, (Response to the

IASC Issues paper on Insurance Accounting), Page 1-3, 10-06-2000

19) The International Accounting Standards Board Comment Letter, KPMG, (IASC

Insurance - Issues paper), Page 1-2, 13-06-2000

20) The International Accounting Standards Board Comment Letter, Dr Richard

Macve, FCA, Professor of Accounting LSE, (Insurance Issues Paper, November

1999), Page 3-34, 26-05-2000

Documents

Life Insurance final - Universiti Kebangsaan Malaysiaaccounting treatment. Also, we will focus into the life and non-life insurance company separately in order to compare the impact