International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards
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2.2.3.B
Assets and liabilities arising from employment benefit plans
Employers’ assets and liabilities under employee benefit plans and retirement benefit
obligations reported by defined benefit retirement plans are excluded from the scope
of IFRS 4. These are accounted for under IAS 19 – Employee Benefits, IFRS 2 – Share-
based Payment – and IAS 26 – Accounting and Reporting by Retirement Benefit Plans.
[IFRS 4.4(b)].
Many defined benefit pension plans and similar post-employment benefits meet the
definition of an insurance contract because the payments to pensioners are contingent
on uncertain future events such as the continuing survival of current or retired
employees. Without this exception they would have been within the scope of IFRS 4.
2.2.3.C
Contingent rights and obligations related to non-financial items
Contractual rights or contractual obligations that are contingent on the future use of, or
right to use, a non-financial item (for example, some licence fees, royalties, contingent
or variable lease payments and similar items) are excluded from the scope of IFRS 4, as
well as a lessee’s residual value guarantee embedded in a lease (see IFRS 15, IFRS 16 –
Leases, IAS 17 – Leases – and IAS 38). [IFRS 4.4(c)].
2.2.3.D Financial
guarantee contracts
Financial guarantee contracts are excluded from the scope of IFRS 4 unless the issuer
has previously asserted explicitly that it regards such contracts as insurance contracts
and has used accounting applicable to insurance contracts, in which case the issuer may
Insurance contracts (IFRS 4) 4291
elect to apply either IAS 32, IAS 39 or IFRS 9 and IFRS 7 or IFRS 4 to them. The issuer
may make that election contract by contract, but the election for each contract is
irrevocable. [IFRS 4.4(d)].
Where an insurer elects to use IFRS 4 to account for its financial guarantee contracts,
its accounting policy defaults to its previous GAAP for such contracts (subject to any
limitations discussed at 7.2 below) unless subsequently modified as permitted by IFRS 4
(see 8 below).
IFRS 4 does not elaborate on the phrase ‘previously asserted explicitly’. However, the
application guidance to IAS 39 and IFRS 9 states that assertions that an issuer regards
contracts as insurance contracts are typically found throughout the issuer’s
communications with customers and regulators, contracts, business documentation and
financial statements. Furthermore, insurance contracts are often subject to accounting
requirements that are distinct from the requirements for other types of transaction, such
as contracts issued by banks or commercial companies. In such cases, an issuer’s
financial statements typically include a statement that the issuer has used those
accounting requirements. [IAS 39.AG4A, IFRS 9.B2.6]. Therefore, it is likely that insurers that
have previously issued financial guarantee contracts and accounted for them under an
insurance accounting and regulatory framework will meet these criteria. It is unlikely
that an entity not subject to an insurance accounting and regulatory framework, or new
insurers (start-up companies) and existing insurers that had not previously issued
financial guarantee contracts would meet this criteria because they would not have
previously made the necessary assertions.
Accounting for financial guarantee contracts by issuers that have not elected to use
IFRS 4 is discussed in Chapter 41 at 3.4.2.
2.2.3.E Contingent
consideration payable or receivable in a business
combination
Contingent consideration payable or receivable in a business combination is outside the
scope of IFRS 4. [IFRS 4.4(e)]. Contingent consideration in a business combination is
required to be recognised at fair value at the acquisition date with subsequent
remeasurements of non equity consideration included in profit or loss. [IFRS 3.58].
2.2.3.F
Direct insurance contracts in which the entity is the policyholder
Accounting by policyholders of direct insurance contracts (i.e. those that are not
reinsurance contracts) is excluded from the scope of IFRS 4 because the IASB did not
regard this as a high priority for Phase I. [IFRS 4.4(f), BC73]. However, holders of
reinsurance contracts (cedants) are required to apply IFRS 4. [IFRS 4.4(f)].
A policyholder’s rights and obligations under an insurance contract are also excluded
from the scope of IAS 32, IAS 39 or IFRS 9 and IFRS 7. However, the IAS 8 –
Accounting Policies, Changes in Accounting Estimates and Errors – hierarchy does
apply to policyholders when determining an accounting policy for direct insurance
contracts. IAS
37 addresses accounting for reimbursements from insurers for
expenditure required to settle a provision and IAS 16 – Property, Plant and Equipment
– addresses some aspects of compensation from third parties for property, plant and
equipment that is impaired, lost or given up. [IFRS 4.BC73].
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The principal outlined in IAS 37 is that reimbursements and contingent assets can only
be recognised if an inflow of economic benefits is virtually certain. [IAS 37.33, 56]. IAS 16
requires that compensation from third parties for property, plant and equipment
impaired, lost or given up is included in profit or loss when it ‘becomes receivable’.
[IAS 16.66(c)]. These are likely to be more onerous recognition tests than any applied
under IFRS 4 for cedants with reinsurance assets which will be based on local
insurance GAAP.
2.2.4
The product classification process
Because of the need to determine which transactions should be within the scope of
IFRS 4, and which transactions are not within its scope, one of the main procedures
required of insurers as part of their first-time adoption of IFRS 4 is to conduct a product
classification review.
Many large groups developed a product classification process to determine the
appropriate classification on a consistent basis. In order to ensure consistency, the
product classification process is typically set out in the group accounting manual.
The assessment of the appropriate classification for a contract will include an
assessment of whether the contract contains significant insurance risk (discussed at 3
below), and whether the contract contains embedded derivatives (discussed at 4 below),
deposit components (discussed at 5 below) or discretionary participation features
(discussed at 6 below).
The diagram below illustrates a product classification decision tree.
Product is an investment contract with
discretionary participation features
Are any elements
– Under IFRS 4 – existing accounting
Classified as an
of the benefit driven
Yes
treatment unchanged.
investment contract
by discretionary
– Contract must be tested for embedded
participation?
derivatives.
– Different considerations based on
classification of distributable surplus.
No
Product is an investment contract without
dis
cretionary participation features
Deposit component
No
– Revert to IAS 39 (or IFRS 9). Need to
determine valuation on a fair value or
Is there significant
amortised cost basis.
Insurance and deposit components of
insurance risk present
– If amortised cost basis used, then
contract must, if not recognised, be
in the contract?
contract must be tested for embedded
unbundled and valued separately
derivatives.
Yes
Insurance
Yes
component
Is there a
Product is an insurance contract
deposit component to
–
Insurance features
No
Under IFRS 4 – existing accounting
the contract? If so, is the deposit
present in contract
treatment unchanged (subject to
component independent
exclusions).
of the insurance
– Contract must be tested for embedded
cashflows?
derivatives.
Insurance contracts (IFRS 4) 4293
3
THE DEFINITION OF AN INSURANCE CONTRACT
3.1 The
definition
The definition of an insurance contract in IFRS 4 is:
‘A contract under which one party (the insurer) accepts significant insurance risk from
another party (the policyholder) by agreeing to compensate the policyholder if a
specified uncertain future event (the insured event) adversely affects the policyholder’.
[IFRS 4 Appendix A].
This definition determines which contracts are within the scope of IFRS 4 rather than
other standards.
The IASB rejected using existing national definitions because they believed it
unsatisfactory to base the definition used in IFRS on definitions that may vary from
country to country and may not be the most relevant for deciding which IFRS ought to
apply to a particular type of contract. [IFRS 4.BC12].
In response to concerns that the definition in IFRS 4 could ultimately lead to changes in
definitions used for other purposes, such as insurance law, insurance supervision or tax,
the IASB made it clear that any definition within IFRS is solely for financial reporting
and is not intended to change or pre-empt definitions used for other purposes.
[IFRS 4.BC13].
This means that contracts which have the legal form of insurance contracts in their
country of issue are not necessarily insurance contracts under IFRS. Conversely,
contracts which may not legally be insurance contracts in their country of issue can be
insurance contracts under IFRS. In the opinion of the IASB, financial statements should
reflect economic substance and not merely legal form.
The rest of this section discusses the definition of an insurance contract in more detail.
3.2 Significant
insurance
risk
A contract is an insurance contract only if it transfers ‘significant insurance risk’.
[IFRS 4.B22].
Insurance risk is ‘significant’ if, and only if, an insured event could cause an insurer to
pay significant additional benefits in any scenario, excluding scenarios that lack
commercial substance (i.e. have no discernible effect on the economics of the
transaction). [IFRS 4.B23].
If significant additional benefits would be payable in scenarios that have commercial
substance, this condition may be met even if the insured event is extremely unlikely or
even if the expected (i.e. probability-weighted) present value of contingent cash flows
is a small proportion of the expected present value of all the remaining contractual cash
flows. [IFRS 4.B23].
From this, we consider the IASB’s intention was to make it easier, not harder, for
contracts regarded as insurance contracts under most local GAAPs to be insurance
contracts under IFRS 4.
Local GAAP in many jurisdictions prohibits insurance contract accounting if there are
restrictions on the timing of payments or receipts. IFRS 4 has no such restrictions,
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provided there is significant insurance risk, although clearly the existence of restrictions
on the timing of payments may mean that the policy does not transfer significant
insurance risk.
3.2.1
The meaning of ‘significant’
No quantitative guidance supports the determination of ‘significant’ in IFRS 4. This was
a deliberate decision because the IASB considered that if quantitative guidance was
provided it would create an arbitrary dividing line that would result in different
accounting treatments for similar transactions that fall marginally on different sides of
that line and would therefore create opportunities for accounting arbitrage. [IFRS 4.BC33].
The IASB also rejected defining the significance of insurance risk by reference to the
definition of materiality within IFRS because, in their opinion, a single contract, or even
a single book of similar contracts, could rarely generate a loss that would be material to
the financial statements as a whole. [IFRS 4.BC34]. The IASB also rejected the notion of
defining significance of insurance risk by expressing the expected (probability weighted)
average of the present values of the adverse outcomes as a proportion of the expected
present value of all outcomes, or as a proportion of the premium. This idea would have
required the constant monitoring of contracts over their life to see whether they
continued to transfer insurance risk. As discussed at 3.3 below, an assessment of
whether significant insurance risk has been transferred is normally only required at the
inception of a contract. [IFRS 4.BC35].
The IASB believes that ‘significant’ means that the insured benefits certainly must be
greater than 101% of the benefits payable if the insured event did not occur and it
expressed this in the implementation guidance as illustrated below. It is, however,
unclear how much greater than 101% the insured benefits must be to meet the definition
of ‘significant’.
Example 51.1: Significant insurance risk
Entity A issues a unit-linked contract that pays benefits linked to the fair value of a pool of assets. The benefit
is 100% of the unit value on surrender or maturity and 101% of the unit value on death.
In this situation the implementation guidance states that if the insurance component (the additional death
benefit of 1%) is not unbundled then the whole contract is an investment contract. The insurance component
in this arrangement is insignificant in relation to the whole contract and so would not meet the definition of
an insurance contract in IFRS 4. [IFRS 4.IG2 E1.3].
Some jurisdictions have their own guidance as to what constitutes significant insurance
risk. However, as with IFRS 4, other jurisdictions offer no quantitative guidance. Some
US GAAP practitioners apply a guideline that a reasonable possibility of a significant
loss is a 10% probability of a 10% loss although this guideline does not appear in US
GAAP itself. [IFRS 4.BC32]. It is not disputed in the basis for conclusions that a 10% chance
of a 10% loss results in a transfer of significant insurance risk a
nd, indeed, the words
‘extremely unlikely’ and ‘a small proportion’ (see 3.2 above) suggests to us that the IASB
envisages that significant insurance risk can exist at a different threshold than a 10%
probability of a 10% loss.
This lack of a quantitative definition means that insurers must apply their own
judgement as to what constitutes significant insurance risk. Although the IASB did not
want to create an ‘arbitrary dividing line’, the practical impact of this lack of guidance is
Insurance contracts (IFRS 4) 4295
that insurers have to apply their own criteria to what constitutes significant insurance
risk and there probably is inconsistency in practice as to what these dividing lines are,
at least at the margins.
There is no requirement under IFRS 4 for insurers to disclose any thresholds used in
determining whether a contract has transferred significant insurance risk. However,
IAS 1 – Presentation of Financial Statements – requires an entity to disclose the
judgements that management has made in the process of applying the entity’s
accounting policies that have the most significant effect on the amounts recognised in
the financial statements (see Chapter 3 at 5.1.1.B). Liverpool Victoria made the following
disclosures about significant insurance risk in its 2016 financial statements.
Extract 51.1: Liverpool Victoria Friendly Society Limited (2016)
Notes to the Financial Statements [extract]
1. Significant
accounting
policies
[extract]
b) Contract
classification [extract]
Insurance contracts are those contracts that transfer significant insurance risk. Such contracts may also transfer financial risk. As a general guideline, the Group defines as significant insurance risk the possibility of having to pay benefits on the occurrence of an insured event that are at least 10% more than the benefits payable if the insured event did not occur.
3.2.2
The level at which significant insurance risk is assessed
Significant insurance risk must be assessed by individual contract, rather than by blocks
of contracts or by reference to materiality to the financial statements. Thus, insurance
risk may be significant even if there is a minimal probability of material losses for a
whole book of contracts. [IFRS 4.B25].