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Pensions Accounting: A matching miss

The shift to a new accounting model was always going to be a challenge for the insurance sector. Until now, the International Accounting Standards Board has relied on a stopgap in the form of International Financial Reporting Standard 4, Insurance Contracts.

That is set to change once the board has completed phase two of its work on IFRS 4 (IFRS 4 P2) to address the measurement of insurance-contract liabilities. But on the asset side insurers must also reckon with the IASB’s new financial instruments accounting standard, IFRS 9, from 2018.

This raises the question of how insurers will manage the inevitable accounting mismatches from holding assets under IFRS 9 and reporting liabilities under the existing accounting model. 

The IASB’s insurance-accounting model applies not just to insurers but the broader notion of insurance contracts. It rests on four building blocks:

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• A probability-weighted calculation of expected future cashflows;
• Discounting;
• A risk adjustment; and
• A contractual service margin (CSM).

The first block requires the issuer of an insurance contract to discount its estimated future cashflows. “Under Solvency II, swap rates provide the base reference for risk-free rates,” explains David Holliday, senior manager and insurance accounting specialist at KPMG

“On top of that you may be able to add a matching adjustment or a volatility adjustment to give a higher discount rate and a lower liability. IFRS 4 P2 is much less prescriptive, meaning an insurer could use higher discount rates to allow for the fact that they do not intend to trade and sell the contract cashflows.”

The third building block is a risk adjustment. Again, IFRS 4 P2 is less prescriptive than Solvency II. For example, insurers can apply virtually any approach they want – cost of capital or confidence limits – as long as it has certain characteristics and they explain it. 

The final block is the CSM. So, once an insurer has calculated its expected cashflows, discounted them and made a risk adjustment at contract inception, an apparently profitable contract should produce an asset. 

However, IFRS 4 P2 prohibits the recognition of day-one profits, so here the IASB has come up the CSM. “Conceptually, the first three building blocks are the best measure of the insurance liability,” David Holliday explains. “The CSM is really a sort of plug or a balancing figure defined as ‘unrecognised profits’.”

That is not the full picture, however, because there are restrictions on what insurers can and cannot include in their cashflows. In essence, they can defer and spread profits – but not losses – by recognising the CSM in P&L over the contract term.

The accounting mismatch issue arises because IFRS 9 looks at the asset side of the balance sheet, while IFRS 4 is focused on the liability side. Fundamentally, there are two types of mismatch – balance-sheet mismatches and P&L mismatches. They can be caused by quite different things. 

At the moment, the way insurers deal with mismatches depends on where in the world they are. In the UK, most insurers use current values for both assets and liabilities, with all of the changes flowing through P&L. So economic mismatches tend to be recognised in P&L and in the balance sheet. 

Outside the UK, the use of historic cost accounting is much more widespread on both the asset and the liability sides of the balance sheet. These insurers have largely avoided mismatches because they use original cost and locked-in assumptions on the liability side on the balance sheet. 

IFRS 9 will, however, upset this apple cart. “Take the asset side,” says Danny Clark, partner at KPMG. “When IFRS 9 comes in from 2018, it will require bond holdings to be measured at fair value in the balance sheet, with any changes in the values of those assets other than the original EIR [effective interest rate] going into OCI [other comprehensive income].” 

The change will be largely irrelevant for many UK insurers; where they have been using fair value through P&L, they will carry on doing that, Clark explains. Currently, some non-life insurers take fair-value gains through OCI using available-for-sale (AFS) accounting under IAS 39. In addition, some UK-headquartered international insurers use AFS for assets held by their non-UK businesses

But, adds Clark, many EU insurers will have mismatches because although their assets are fair valued, they will continue to measure liabilities using locked-in assumptions – causing volatility in equity and P&L. 

He adds: “It is quite a complex story. If you are using locked-in assumptions you are going to move to a prospective calculation using current assumptions similar to Solvency II, so the liability will become quite volatile because of the economics that underpin the valuation.

“You will then have a situation where you have volatility on your liabilities and you have volatility on the assets that back them. From an accounting perspective, you could either take it all through OCI or you can take that through the income statement for both assets and liabilities.”

Meanwhile, the IASB has attempted to address the difficulties that result from the different dates of IFRS 9 and IFRS 4 P2. In an exposure draft issued just before Christmas, the board proposes two interim solutions. The solution needs only to be a temporary fix because the accounting mismatch issue largely disappears once IFRS 4 P2 kicks in.

The first, is an overlay approach and offers the option of parking volatility that arises from the application of IFRS 9 outside P&L. 

The second, is the so-called deferral approach. This amounts to a temporary exemption from applying IFRS 9 for companies whose main activity is issuing insurance contracts.

Andrew Carpenter, policy adviser for financial regulation and taxation at the Association of British Insurers says that although the assocation welcomes the IASB’s willingness to come up with a solution, it is concerned that the scope of the deferral option is too narrow.

“In principle, the IASB’s IFRS 9 deferral option should achieve the alignment the industry has wanted. In practice, however, the IASB’s criteria for using the option are too narrow,” Carpenter says.

“Many insurers could be excluded, even some that the Financial Stability Board recognise as globally systemic. A more workable approach can still achieve the IASB’s key objectives, and the industry will respond to the IASB’s consultation accordingly.”

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