Adequacy of Insurance Liabilities
IFRS 4 imposes a liability adequacy test, which requires that at each reporting date the “insurer” must assess whether its recognised insurance liabilities are adequate, using then‐current estimates of future cash flows under the outstanding insurance contracts. If as a result of that
assessment it is determined that the carrying amount of insurance liabilities (less related deferred acquisition costs and related intangible assets, if appropriate—see discussion below) is insufficient given the estimated future cash flows, the full amount of such deficiency must be reported currently in earnings.
The standard defines minimum requirements for the adequacy test that is to be applied to the liability account. These minimum requirements are that:
1. The test considers the current estimates of all contractual cash flows, and of such related cash flows as claims handling costs, as well as cash flows that will result from embedded options and guarantees.
2. If the test shows that the liability is inadequate, the entire deficiency is recognised in profit or loss.
In situations where the insuring entity's accounting policies do not require a liability adequacy test, or provide for a test that does not meet the minimum requirements noted above, then the entity is required under IFRS 4 to:
1. Determine the carrying amount of the relevant insurance liabilities, less the carrying amount of:
1. Any related deferred acquisition costs; and
2. Any related intangible assets, such as those acquired in a business combination or portfolio transfer. However, related reinsurance assets are not considered because an insurer accounts for them separately.
2. Determine whether the carrying amount of the relevant net insurance liabilities is less than the carrying amount that would be required if the relevant insurance liabilities were within the scope of IAS 37. If it is less, the insurer shall recognise the entire difference in profit or loss and decrease the carrying amount of the related deferred acquisition costs or related intangible assets or increase the carrying amount of the relevant insurance liabilities.
The IAS 37‐based amount is the required minimum liability to be presented. Therefore, if the current carrying amount is less, the insuring entity must recognise the entire shortfall in current period earnings. The corresponding credit to this loss recognition will either decrease the carrying amount of the related deferred acquisition costs or related intangible assets or increase the carrying amount of the relevant insurance liabilities, or both, dependent upon the facts and circumstances.
In applying the foregoing procedures, any related reinsurance assets are not considered, because an insuring entity accounts for these separately, as noted later in this discussion.
If an insuring entity's liability adequacy test meets the minimum requirements set forth above, this test is applied at the level of aggregation specified above. On the other hand, if the liability adequacy test does not meet the stipulated minimum requirements, the comparison must instead be made at the level of a portfolio of contracts that are subject to broadly similar risks and which are managed together as a single portfolio.
For purposes of comparing the recorded liability to the amount required under IAS 37, it is acceptable to reflect future investment margins only if the carrying amount of the liability also reflects those same margins. Future investment margins are defined under IFRS 4 as being employed if the discount rate used reflects the estimated return on the insuring entity's assets, or if the returns on those assets are projected at an estimated rate of return, and discounted at a different rate, with the result included in the measurement of the liability. There is a rebuttable presumption that future investment margins should not be used; however, exceptions (see below) can exist.
Impairment testing of reinsurance assets
When an insuring entity obtains reinsurance (making it the cedant), an asset is created in its financial statements. As with other assets, the reporting entity must consider whether an impairment has occurred as of the reporting date. Under IFRS 4, a reinsurance asset is impaired only when there is objective evidence that the cedant may not receive all amounts due to it under the terms of the contract, as a consequence of an event that occurred after initial recognition of the reinsurance asset, and furthermore the impact of that event is reliably measurable in terms of the amounts that the cedant will receive from the reinsurer.
When the reinsurance asset is found to be impaired, the carrying amount is adjusted downward and a loss is recognised in current period earnings for the full amount.
Selection of Accounting Principles
IFRS requires certain accounting practices to be adopted with regard to insurance contracts, but also allows other, existing procedures to remain
in place under defined conditions. An insuring entity may, under the provisions of IFRS 4, change accounting policies for insurance contracts only if such change makes the financial statements more relevant to the economic decision‐making needs of users and no less reliable or more reliable and no less relevant to those needs. Relevance and reliability are to be assessed by applying the criteria set forth in IAS 8.
To justify changing its accounting policies for insurance contracts, an insuring entity must demonstrate that the change brings its financial statements nearer to satisfying the criteria of IAS 8, but the change does not necessarily have to achieve full compliance with those criteria. The standard addresses changes in accounting policies in the context of current interest rates; continuation of existing reporting practices; prudence;
future investment margins; and “shadow accounting.” These are discussed in the following paragraphs.
Regarding interest rates, IFRS 4 provides that an insuring entity is permitted, although it is not required, to change its accounting policies such that it remeasures designated insurance liabilities to reflect current market interest rates, and recognises changes in those liabilities in current period earnings. It may also adopt accounting policies that require other current estimates and assumptions for the designated liabilities. IFRS 4 permits an insuring entity to change its accounting policies for designated liabilities, without consistently applying those policies to all similar liabilities, as the requirements under IAS 8 would suggest. If the insuring entity designates liabilities for this policy choice, it must continue to apply current market interest rates consistently in all periods to all these liabilities until they are later eliminated.
An unusual feature of IFRS 4 is that it offers affected reporting entities the option to continue with their existing accounting policies. Specifically, an insuring entity is allowed to continue the following practices if in place prior to the effective date of IFRS 4:
1. Measuring insurance liabilities on an undiscounted basis.
2. Measuring contractual rights to future investment management fees at an amount that exceeds their fair value as implied by a comparison with current fees charged by other market participants for similar services. It is likely that the fair value at inception of those contractual rights equals the origination costs paid, unless future investment management fees and related costs are out of line with market comparables.
3. Employing non‐uniform accounting policies for the insurance contracts (and related deferred acquisition costs and intangible assets, if any) of subsidiaries, except as permitted by the above‐noted interest provision. If those accounting policies are not uniform, the insuring entity may change them if the change does not make the accounting policies more diverse, and also satisfies the other requirements of the standard.
The concept of prudence, as set forth in IFRS 4, is meant to excuse an insuring entity from a need to change its accounting policies for insurance contracts to eliminate excessive prudence (i.e., conservatism). However, if the insuring entity already measures its insurance contracts with sufficient prudence, it is not permitted to introduce additional prudence following adoption of IFRS 4.
The matter of future investment margins requires some explanation. Under IFRS 4 it is clearly preferred that the measurement of insurance contracts should not reflect future investment margins, but the standard does not require reporting entities to change accounting policies for insurance contracts to eliminate future investment margins. On the other hand, adopting a policy that would reflect this is presumed to be improper (the standard states that there is a rebuttable presumption that the financial statements would become less relevant and reliable if an accounting policy that reflects future investment margins in the measurement of insurance contracts is adopted, unless those margins affect the contractual payments). The standard offers two examples of accounting policies that reflect those margins. The first is using a discount rate that reflects the estimated return on the insurer's assets, while the second is projecting the returns on those assets at an estimated rate of return, discounting those projected returns at a different rate and including the result in the measurement of the liability.
IFRS 4 states that the insuring entity could possibly overcome this rebuttable presumption if the other components of a change in accounting policies increase the relevance and reliability of its financial statements sufficiently to outweigh the decrease in relevance and reliability caused by the inclusion of future investment margins. As an example, it cites the situation where the existing accounting policies for insurance contracts involve excessively prudent (i.e., conservative) assumptions set at inception, and a statutory discount rate not directly referenced to market conditions and ignore some embedded options and guarantees. This entity might make its financial statements more relevant and no less reliable by switching to a comprehensive investor‐oriented basis of accounting that is widely used and involves current estimates and assumptions; a reasonable (but not excessively prudent) adjustment to reflect risk and uncertainty; measurements that reflect both the intrinsic value and time value of embedded options and guarantees; and a current market discount rate, even if that discount rate reflects the estimated return on the insuring entity's assets.
The actual ability to overcome IFRS 4's rebuttable presumption is fact dependent. Thus, in some measurement approaches, the discount rate is used to determine the present value of a future profit margin, which is then attributed to different periods using a formula. In such approaches, the discount rate affects the measurement of the liability only indirectly, and the use of a less appropriate discount rate has limited or no effect on the measurement of the liability at inception. In yet other approaches, the discount rate determines the measurement of the liability directly, and because the introduction of an asset‐based discount rate has a more significant effect, it is highly unlikely that an insurer could overcome the rebuttable presumption noted above.
Finally, there is the matter of shadow accounting. According to IFRS 4, an insurer is permitted, but not required, to change its accounting policies so that a recognised but unrealised gain or loss on an asset affects those measurements in the same way that a realised gain or loss does. This is because, under some accounting models, realised gains or losses on an insurer's assets have a direct effect on the measurement of some or all of: (1) its insurance liabilities; (2) related deferred acquisition costs; and (3) related intangible assets. IFRS 4 provides that the related adjustment to the insurance liability (or deferred acquisition costs or intangible assets) may be recognised in equity if, and only if, the unrealised gains or losses are recognised directly in equity.
Unbundling
Specific requirements pertain to unbundling of elements of insurance contracts, and dealing with embedded derivatives, options and guarantees.
Unbundling refers to the accounting for components of a contract as if they were separate contracts. Some insurance contracts consist of an insurance component and a deposit component. IFRS 4 in some cases requires the reporting entity to unbundle those components, and in other fact situations provides the entity with the option of unbundled accounting. Specifically, unbundling is required if both the following conditions are met:
1. The insuring entity can measure the deposit component (inclusive of any embedded surrender options) separately (i.e., without considering the insurance component); and
2. The insuring entity's accounting policies do not otherwise require it to recognise all obligations and rights arising from the deposit component.
On the other hand, unbundling is permitted, but not required, if the insuring entity can measure the deposit component separately but its
accounting policies require it to recognise all obligations and rights arising from the deposit component, regardless of the basis used to measure those rights and obligations.
Unbundling is actually prohibited if an insuring entity cannot measure the deposit component separately. If unbundling is applied to a contract, the insuring entity applies IFRS 4 to the insurance component of the contract, while using IFRS 9 to account for the deposit component of that contract.
Recognition
IFRS 4 prohibits the recognition of a liability for any provisions for possible future claims, if those claims arise under insurance contracts that are not in existence at the reporting date. Catastrophe and equalisation provisions are thus prohibited, because they do not reflect loss events that have already occurred and therefore recognition would be inconsistent with IAS 37. Loss recognition testing is required for losses already incurred at each date of the statement of financial position, as described above. An insurance liability (or a part of an insurance liability) is to be removed from the statement of financial position only when it is extinguished (i.e., when the obligation specified in the contract is discharged or cancelled or expires).
In terms of display, offsetting of reinsurance assets against the related insurance liabilities is prohibited, as is offsetting of income or expense from reinsurance contracts against the expense or income from the related insurance contracts.
Discretionary Participation Features in Insurance Contracts
Insurance contracts sometimes contain a discretionary participation feature, as well as a guaranteed element. (That is, some portion of the return to be accrued to policyholders is at the discretion of the insuring entity.) Under the provisions of IFRS 4, the issuer of such a contract may, but is not required to, recognise the guaranteed element separately from the discretionary participation feature. If the issuer does not recognise them separately, it must classify the entire contract as a liability. If, on the other hand, the issuer classifies them separately, it will classify the guaranteed element as a liability. If the entity recognises the discretionary participation feature separately from the guaranteed element, the discretionary participation feature can be classified either as a liability or as a separate component of equity; the standard does not specify how the decision should be reached. In fact, the issuer may even split that feature into liability and equity components, if a consistent accounting policy is used to determine that split.
When there is a discretionary participation feature which is reported in equity, the reporting entity is permitted to recognise all premiums received as revenue, without separating any portion that relates to the equity component. Changes in the guaranteed element and in the portion of the discretionary participation feature classified as a liability are to be reported in earnings, while changes in the part of the discretionary participation feature classified as equity are to be accounted for as an allocation of earnings, similar to how minority interest is reported.
Embedded Derivatives
If the contract contains an embedded derivative within the scope of IFRS 9, that standard must be applied to that embedded derivative.
DISCLOSURE
Under the provisions of IFRS 4, insuring entities must disclose information that identifies and explains the amounts in its financial statements arising from insurance contracts. This is accomplished by disclosure of accounting policies for insurance contracts and related assets, liabilities, income and expense; of recognised assets, liabilities, income and expense (and, if it presents its statement of cash flows using the direct method, cash flows) arising from insurance contracts. Additionally, if the insuring entity is a cedant, it must also disclose gains and losses recognised in profit or loss on buying reinsurance; and, if the cedant defers and amortises gains and losses arising on buying reinsurance, the amortisation for the period and the amounts remaining unamortised at the beginning and end of the period.
Disclosure is also required of the process used to determine the assumptions that have the greatest effect on the measurement of the recognised amounts described above. When practicable, quantified disclosure of those assumptions is to be presented as well. The effect of changes in assumptions used to measure insurance assets and insurance liabilities is required, reporting separately the effect of each change that has a material effect on the financial statements.
Finally, reconciliation of changes in insurance liabilities, reinsurance assets and, if any, related deferred acquisition costs are mandated by IFRS 4.
Regarding the amount, timing and uncertainty of cash flows, the entity is required to disclose information that helps users to understand these matters as they result from insurance contracts. This is accomplished if the insuring entity discloses its objectives in managing risks arising from insurance contracts and its policies for mitigating those risks.
Applying IFRS 9 with IFRS 4
IFRS 4 was amended September 2016 to create a temporary exception for insurers to remain applying IAS 39 rather than IFRS 9 for annual periods beginning before January 1, 2021, if the insurer's activities are predominantly connected with insurance. If the entities activities are not predominantly connected with insurance, an overlay approach may be applied, under which the difference between the IFRS 9 and IAS 39 treatment is recognised in other comprehensive income.
The temporary exemptions from IFRS 9 and the overlay approach are also available to an issuer of a financial instrument that contains a discretionary participation feature.
Temporary exemption from IFRS 9
An insurer may apply the temporary exemption from IFRS 9 if it has not previously applied any version of IFRS 9 (except for applying the requirement in IFRS 9 that the effect of changes in credit risk of a liability are recognised in other comprehensive income for financial liability designated at fair value through profit or loss) and its activities are predominantly connected with insurance, at its annual reporting date that immediately precedes April 1, 2016, or at a subsequent annual reporting date specified.
After April 1, 2016, an entity applying the temporary exception should reassess whether its activities are predominantly connected with insurance at a subsequent annual reporting date if there was a change in the entity's activities. An entity that previously did not qualify for the temporary exemption from IFRS 9 is permitted to reassess whether its activities are predominantly connected with insurance at subsequent annual reporting dates before December 31, 2018, only if there was a change in the entity's activities during that annual period. The standard provides additional guidance on what constitutes a change in an entity's activities.
If an entity no longer qualifies for the temporary exemption from IFRS 9 as a result of a reassessment, then the entity is permitted to continue to apply the temporary exemption from IFRS 9 only until the end of the annual period that began immediately after that reassessment. An insurer that previously elected to apply the temporary exemption from IFRS 9 may at the beginning of any subsequent annual period irrevocably elect to apply IFRS 9.
An entity applying the temporary exception from IFRS 9 may apply the requirement in IFRS 9 that the effect of changes in credit risk of a liability are recognised in other comprehensive income for financial liability designated at fair value through profit or loss.
An insurer's activities are predominantly connected with insurance if:
1. The carrying amount of its liabilities arising from contracts within the scope of IFRS 4, which includes any deposit components or embedded derivatives unbundled from insurance contracts, is significant compared to the total carrying amount of all its liabilities; and 2. The percentage of the total carrying amount of its liabilities connected with insurance relative to the total carrying amount of all its liabilities
is:
1. Greater than 90%; or
2. Less than or equal to 90% but greater than 80%, and the insurer does not engage in a significant activity unconnected with insurance.
The standard provides further guidance on assessing whether an entity engages in significant unconnected activities.
Liabilities connected with insurance comprise:
1. Liabilities arising from contracts within the scope of IFRS 4;
2. Non‐derivative investment contract liabilities measured at fair value through profit or loss applying IAS 39 (including those designated as at fair value through profit or loss to which the insurer has applied the requirements in IFRS 9 for the presentation of gains and losses); and 3. Liabilities that arise because the insurer issues, or fulfils obligations arising from, the above contracts. Examples of such liabilities include
derivatives used to mitigate risks arising from those contracts and from the assets backing those contracts, relevant tax liabilities such as the deferred tax liabilities for taxable temporary differences on liabilities arising from those contracts and debt instruments issued that are included in the insurer's regulatory capital.
A first‐time adopter of IFRS may apply the temporary exemption from IFRS 9 if it meets the criteria for applying the temporary exemption as described above.
Situations may exist where an insurer applies the temporary exceptions from IFRS 9 but its associates or joint ventures do not, or vice versa. For annual periods beginning before January 1, 2021, the entity is permitted to retain the relevant accounting policies applied by the associate or joint venture as follows:
1. The entity applies IFRS 9 but the associate or joint venture applies the temporary exemption from IFRS 9; or 2. The entity applies the temporary exemption from IFRS 9 but the associate or joint venture applies IFRS 9.
An entity may apply the requirements separately for each associate or joint venture.
When an entity uses the equity method to account for its investment in an associate or joint venture:
1. IFRS 9 shall continue to be applied, if it was previously applied in the financial statements used to apply the equity method to that associate or joint venture (after reflecting any adjustments made by the entity).
2. IFRS 9 might be subsequently applied, if the temporary exemption from IFRS 9 was previously applied in the financial statements used to apply the equity method to that associate or joint venture (after reflecting any adjustments made by the entity).
An entity may apply the requirements above separately for each associate or joint venture.
Disclosures about the temporary exemption from IFRS 9
The disclosure objective for an insurer that elects to apply the temporary exemption from IFRS 9 is to disclose information to enable users of financial statements:
1. To understand how the insurer qualified for the temporary exemption; and
2. To compare insurers applying the temporary exemption with entities applying IFRS 9.
To achieve this disclosure objective, an insurer shall disclose:
1. The fact that it is applying the temporary exemption from IFRS 9 and how the insurer concluded that it qualified for the temporary exemption from IFRS 9, including:
1. If the carrying amount of its liabilities arising from contracts within the scope of this IFRS was less than or equal to 90% of the total carrying amount of all its liabilities, the nature and carrying amounts of the liabilities connected with insurance that are not liabilities arising from contracts within the scope of this IFRS;
2. If the percentage of the total carrying amount of its liabilities connected with insurance relative to the total carrying amount of all its liabilities was less than or equal to 90% but greater than 80%, how the insurer determined that it did not engage in a significant activity unconnected with insurance, including what information it considered; and