The IASB met on 19 and 20 January 2016 to discuss the level of aggregation of contracts for allocation of the contractual service margin (CSM) and losses from onerous contracts. They also discussed the definition of discretion in the context of participating contracts that follow the general model.
The IASB tentatively decided to require entities to group contracts to assess onerous contracts based on cash flows responding similarly to key risk drivers and similar expected profitability. The IASB did not vote on the specific wording for grouping of contracts for CSM allocation which will be addressed in drafting. The IASB did, however, vote in favour of a principle to permit grouping of homogeneous contracts and to provide clarification in the new insurance contracts standard (the Standard) on what acceptable and unacceptable groupings could be. The IASB voted to permit no exception on the level of aggregation for situations where regulation affects the pricing of contracts.
The IASB also discussed how an insurer should distinguish changes in discretionary cash flows that adjust the CSM from changes caused by market variables for participating contracts following the general model. The IASB tentatively decided to require entities to define discretion at the inception of each contract based on the promise the entity makes to its policyholders and agreed to provide examples in the Standard of what constitutes appropriate and inappropriate definitions of discretion.
The Staff expects in February 2016 to ask the IASB to review the due process steps undertaken in developing the Standard and ask for permission to begin the balloting process for the new insurance contracts standard. The Staff has not yet developed drafting timetable but they acknowledged the size and complexity of the Standard which may require long period for drafting. The Board is expected to consider the mandatory effective date of the Standard when the publication date is more certain.
Level of aggregation
Calculation of loss from onerous contracts
All Board members voted in favour of the Staff recommendation to require entities to assess onerous contracts on a portfolio basis, where a portfolio is defined as a group of contracts that
(1) have cash flows that an entity expects will respond in similar ways to key risk drivers in terms of amount and timing and
(2) have similar expected profitability.
The allocation of a contract to a portfolio should be made at inception of each contract and should not be reassessed thereafter.
Board members supported their preference for portfolio-based calculations of loss from onerous contracts by noting that a portfolio-based approach is closer to the way insurers see their business. In addition, their outreach has revealed that an individual contract level would not be operationally feasible.
A few Board members suggested that additional guidance is required for the word ‘similar’ used in Staff recommendations because it requires significant judgement and may result in significantly different outcomes depending on how the judgement is exercised.
The Board considered and rejected the use of ‘pricing’ instead of ‘profitability’ because they found ‘profitability’ to be more relevant for testing onerous contracts.
Allocation of CSM
12 out of 14 Board members voted in favour of a principle to permit grouping of homogeneous contracts for CSM allocation, provided the Standard gives further guidance on permissible criteria for aggregation. The IASB did not conclude what words should be used to describe the principle which will be addressed in drafting.
A few Board members questioned if the Board wants to keep the objective as allocation of CSM at the individual contract level. Ultimately, the Board vote seemed to indicate support for the individual contract level or a grouping of very homogeneous contracts (with indicators or criteria to be determined in the Staff’s drafting).
A few Board members expressed a preference for consistency in the aggregation requirements for measurement of all components of insurance contracts or at least for allocation of CSM and calculation of loss from onerous contracts. They believe this may be operationally simpler, reduce opportunities for earnings management and increase consistency and be more understandable. Other Board members considered that the level of aggregation should fit the purpose of measurement, for example, measurement of expected cash flows is done at a portfolio level, the risk adjustment should consider benefits from diversification of portfolios, while calculation of losses from onerous contracts should consider profitability. Different drivers of measurement result in the need for different aggregation levels.
A few Board members considered that aggregation based on cohorts with similar end of coverage period as initially proposed by Staff was inappropriate, because in practice profitability is often interdependent between different ‘generations’ of contracts. Some Board members suggested that lapses and underwriting of new contracts change the allocation of CSM between existing and new contracts.
A few Board members suggested that having examples on the appropriate and inappropriate level of aggregation in the Standard will help to better understand the principle.
Effect of price regulation
10 out of 14 Board members voted in favour of no exception to the level of aggregation when regulation affects the pricing of contracts.
A few Board members expressed support for no exception arguing that users would need the information about different profitability and level of risk and there are no exceptions for regulated activities in other IFRS. In addition, it would be difficult to define regulation and what kind of regulation would be in scope of the exception.
A few Board members supported the exception because it is wrong to book day one loss for some contracts and recognise higher profits in later periods for others because this does not reflect the economics of the contracts. In substance regulators require insurers to disregard certain risk in making pricing decisions and insurers do not have the option to turn down contracts with unfavourable pricing. Those terms are different from voluntary pricing decisions insurers make because, in cases of unfavourable terms in unregulated environments, insurers can decide not to issue the contract.
Discretion in participating contracts under the general model
The Board decided at previous meetings that changes in estimates of cash outflows that arise as a consequence of changes in market variables (for example changes in interest rates and asset gains or losses), and the corresponding change in discount rates, would be recognised in the Statement of Comprehensive Income. In contrast, changes in estimates that arise as a result of changes in the application of discretion, such as changes in the participation percentage for policyholder crediting, affect the consideration the entity will receive from the contract and adjust the CSM. At the January meeting the Board finalised the b) discussion on how to clarify what constitutes this discretion.
At the January meeting, all Board members voted in favour of the approach that would require an entity to define discretion at (inception of a contract based on the promise it makes to policyholders, and to use it to distinguish between the effect of changes in market variables and changes in discretion throughout the life of the contract.
The Board considered an example of a participating contract with a 2% guaranteed return to policyholders, with additional return at the entity’s discretion. At inception the entity expects to generate a 5% return on assets and to retain a spread of 0.5%. The entity invests in assets that return a fixed rate of 5% for two years.
One day after inception, interest rates fall to 1%. The entity then expects to give the policyholders 4.5% for two years, and then the guaranteed return of 2% thereafter.
The Staff considered the following options to define discretion:
(a) Promise to policyholder is a 4.5% return, entity uses its discretion to reduce that return, subject to the guarantee.
(b) Promise to policyholder is the return on assets it holds, less 0.5% spread, or the guaranteed return if higher. Entity has not used its discretion to change the promise.
(c) Promise to policyholder is a return based on market conditions, less 0.5% spread, or the guaranteed return if higher. Entity uses its discretion to increase the return to policyholders to 4.5% for the first two years.
Promise to policyholder is the guaranteed return of 2%. Additional return is the effect of discretion.
Based on this example presented at a prior Board meeting, Board members previously supported either option (b) or (c), but neither was viewed as ideal. At the January meeting, the new decision to require an entity to define discretion at inception of a contract based on the promise it makes to policyholders was viewed as a combination of both options (b) and (c) above. A few Board members noted that an entity’s promise to policyholders should determine how the discretion is defined. Depending on how the promise is defined the following definitions of the discretion at the inception of a contract can be acceptable (ignoring the effect of the guarantee):
- Adjustments to the return from the underlying assets less a spread; or
- Adjustments to the returns based on market conditions less a spread.
One Board member also suggested to include examples in the Standard, which would demonstrate acceptable and unacceptable definitions of discretion.