At the end of last month the IASB published IFRS4 on insurance contracts. While the standard fills a gap in international accounting standards, which could have prevented insurers from meeting the European 2005 deadline, it is a short-term fix rather than a long-term solution.
Link:IAS special report
The IASB have a project in place to develop a phase II standard for Insurance contracts, but that is not expected until 2007 at the very earliest.
The need to develop a new standard is a major challenge for the IASB and the financial services industry. This is due to the numerous accounting models for insurance contracts in use around the world, many of which are currently incompatible with the IASB’s overall framework.
IFRS4 will allow most aspects of these models to continue in the short-term. It will however prevent certain practices that clearly conflict with the framework, such as the creation of catastrophe and equalisation provisions by general insurers. The standard introduces new disclosures, designed to improve comparability and provide additional information on the risks within insurance contracts.
For example, companies will be required to provide analyses of movements in liabilities and the impact of changes to assumptions. However, one of the objectives in the development of the standard was to avoid introducing costly systems changes that would become redundant for phase II.
Therefore many of the required disclosures are likely to be qualitative or, where numerical, provided at an aggregate level. Given that there are also various exemptions on IFRS1 covering first time application of IFRS, it is questionable whether the disclosure changes will add clarity and improve comparability.
The aspects of the standard that will present the greatest challenge for insurers are the definition of an insurance contract and the requirement to account for investments under IAS39.
The IASB’s intention is that the definition of an insurance contract introduced by IFRS4 will continue to apply at phase II, as a result it has provided considerable guidance on the definition.
Some products will no longer be accounted for as insurance contracts, but instead as financial instruments under IAS39 or as service contracts under IAS18. In the UK, this will include certain investment bonds and pension contracts, particularly if the contracts are unit linked.
Most general insurance contracts will meet the definition, although some reinsurance contracts will need to be unbundled and accounted for as separate deposit and insurance components. This should not be too onerous following recent changes to UK GAAP. Some services, such as breakdown cover, may now be treated as insurance, although the accounting impact will be minimal until we reach phase II. Companies will need to perform a product classification exercise and determine how to account for products that are no longer to be treated as insurance at an early stage in their IFRS conversion project.
In the UK listed insurers typically report an operating profit based on a smoothed, longer-term rate of return on their investments. Under IFRS, investments will mainly be accounted for under IAS39, potentially leading to mismatches between assets and liabilities and increased volatility in reported results. The ability to analyse and explain this volatility will be critical.
Now that IFRS4 has been published, attention is starting to return to the matter of phase II.
The IASB has outlined the principles for phase II, but there remains considerable uncertainty, particularly as to whether the standard will require a fair value approach to measuring insurance liabilities. If it is to avoid the problems experienced in developing IAS39, the IASB will need to engage interested parties throughout the development of the standard.
Equally, insurers will need to provide constructive assistance to create a standard that provides the genuine comparability and clarity required by users.