but in practice contracts will not have a stated discount rate. The issuer and the cedant
will therefore have to determine an appropriate discount rate in order to calculate the
fair value of the deposit component. The IASB illustration is also unclear as to whether
the discount rate is a risk adjusted rate. Fair value measurement would require an
adjustment for credit risk.
4316 Chapter 51
However, the potential burden on insurers is reduced by the fact that the IASB has limited
the requirement to unbundle to only those contracts where the rights and obligations
arising from the deposit component are not recognised under insurance accounting. As
noted above the IASB is principally concerned with ensuring that large reinsurance
contracts with a significant financing element have all of their obligations properly
recorded, although the requirements apply equally to direct insurance contracts. [IFRS 4.IG5].
Some examples of clauses within insurance contracts that might indicate the need for
unbundling are:
• ‘funds withheld’ clauses where part or all of the premium is never paid to the
reinsurer or claims are never received;
• ‘no claims bonus’, ‘profit commission’ or ‘claims experience’ clauses which
guarantee that the cedant will receive a refund of some of the premium;
• ‘experience accounts’ used to measure the profitability of the contract. These are
often segregated from other funds and contain interest adjustments that may
accrue to the benefit of the policyholder;
• ‘finite’ clauses that limit maximum losses or create a ‘corridor’ of losses not
reinsured under a contract;
• contracts that link the eventual premium to the level of claims;
• commutation clauses whose terms guarantee that either party will receive a refund
of amounts paid under the contract; and
• contracts of unusual size where the economic benefits to either party are not
obviously apparent.
The unbundling requirements in IFRS 4 do not specifically address the issue of contracts
artificially separated through the use of side letters, the separate components of which
should be considered together. The IASB believes that it is a wider issue for a future
project on linkage (accounting for separate transactions that are connected in some way).
However, IFRS 4 does state that linked contracts entered into with a single counterparty
(or contracts that are otherwise interdependent) form a single contract, for the purposes
of assessing whether significant insurance risk is transferred, although the standard is
silent on linked transactions with different counterparties (see 3.2.2 above). [IFRS 4.BC54].
6
DISCRETIONARY PARTICIPATION FEATURES
A discretionary participation feature (DPF) is a contractual right to receive, as a
supplement to guaranteed benefits, additional benefits:
(a) that are likely to be a significant portion of the total contractual benefits;
(b) whose amount or timing is contractually at the discretion of the issuer; and
(c) that are contractually based on:
(i)
the performance of a specified pool of contracts or a specified type of contract;
(ii) realised and/or unrealised investment returns on a specified pool of assets
held by the issuer; or
(iii) the profit or loss of the company, fund or other entity that issues the contract.
[IFRS 4 Appendix A].
Insurance contracts (IFRS 4) 4317
Guaranteed benefits are payments or other benefits to which the policyholder or
investor has an unconditional right that is not subject to the contractual discretion of
the issuer. Guaranteed benefits are always accounted for as liabilities.
Insurance companies in many countries have issued contracts with discretionary
participation features. For example, in Germany, insurance companies must return to the
policyholders at least 90% of the investment profits on certain contracts, but may give
more. In France, Italy, the Netherlands and Spain, realised investment gains are
distributed to the policyholder, but the insurance company has discretion over the timing
of realising the gains. In the United Kingdom, bonuses are added to the policyholder
account at the discretion of the insurer. These are normally based on the investment
return generated by the underlying assets but sometimes include allowance for profits
made on other contracts. The following are two examples of contracts with a DPF.
Example 51.27: Unitised with-profits policy
Premiums paid by the policyholder are used to purchase units in a ‘with-profits’ fund at the current unit price.
The insurer guarantees that each unit added to the fund will have a minimum value which is the bid price of
the unit. This is the guaranteed amount. In addition, the insurer may add two types of bonus to the with-profits
units. These are a regular bonus, which may be added daily as a permanent increase to the guaranteed amount,
and a final bonus that may be added on top of those guaranteed amounts when the with-profits units are
cashed in. Levels of regular and final bonuses are adjusted twice per year. Both regular and final bonuses are
discretionary amounts and are generally set based on expected future returns generated by the funds.
Example 51.28: DPF with minimum interest rates
An insurance contract provides that the insurer must annually credit each policyholder’s ‘account’ with a
minimum interest rate (3%). This is the guaranteed amount. The insurer then has discretion with regard to
whether and what amount of the remaining undistributed realised investment returns from the assets backing
the participating policies are distributed to policyholders in addition to the minimum. The contract states that
the insurer’s shareholders are only entitled to share up to 10% in the underlying investment results associated
with the participating policies. As that entitlement is up to 10%, the insurer can decide to credit the
policyholders with more than the minimum sharing rate of 90%. Once any additional interest above the
minimum interest rate of 3% is credited to the policyholder it becomes a guaranteed liability.
DPF can appear in both insurance contracts and investment contracts. However, to
qualify as a DPF, the discretionary benefits must be likely to be a ‘significant’ portion of
the total contractual benefits. The standard does not quantify what is meant by
‘significant’ but it could be interpreted in the same sense as in the definition of an
insurance contract (see 3.2.1 above).
The definition of a DPF does not capture an unconstrained contractual discretion to set
a ‘crediting rate’ that is used to credit interest or other returns to policyholders (as found
in contracts described in some countries as ‘universal life’ contracts). For example, some
contracts may not meet the criterion of (c) above if the discretion to set crediting rates
is not contractually bound to the performance of a specified pool of assets or the profit
or loss of the entity or fund that issues the contract. The IASB, however, acknowledges
that some view these features as similar to a DPF because crediting rates are constrained
by market forces and it proposed to revisit the treatment of these features in what
became IFRS 17. [IFRS 4.BC162].
> With contracts that have discretionary features, the issuer has discretion over the
amount and/or timing of distributions to policyholders although that discretion may be
4318 Chapter 51
subject to some contractual constraints (including related legal and regulatory
constraints) and competitive constraints. Distributions are typically made to
policyholders whose contracts are still in force when the distribution is made. Thus, in
many cases, a change in the timing of a distribution, apart from the change in the value
over time, means that a different generation of policyholders might benefit. [IFRS 4.BC154].
Although the issuer has contractual discretion over distributions it is usually likely that
current or future policyholders will ultimately receive some, if not most, of the
accumulated surplus available at the reporting date. In Example 51.28 above policyholders
are contractually entitled to a minimum of 90% of any discretionary distribution.
Management can decide on any (total) amount. The main accounting question is whether
that part of the discretionary surplus is a liability or a component of equity. [IFRS 4.BC155].
The problem caused by discretionary features is that it is difficult to argue they meet
the definition of a liability under IFRS. However, they can be integral to the economics
of a contract and would clearly have to be considered in determining its fair value.
The definition of a liability in the IASB’s Conceptual Framework for Financial Reporting
(‘Framework’) requires there to be an obligation. An obligation is a duty or responsibility
that an entity has no practical ability to avoid. [CF 4.29]. This can be contractual or
constructive. However, a financial liability under IAS 32 must be a ‘contractual
obligation’ [IAS 32.11] and discretionary obligations normally would not meet this
requirement because of their discretionary nature.
IAS 37 requires provisions to be established once an ‘obligating event’ has occurred.
Obligating events can be constructive but constructive obligations do require an entity
to have indicated its responsibilities to other parties by an established pattern of past
practice, published policies, or a sufficiently specific current statement, such that the
entity has created a valid expectation on the part of those other parties that it will
discharge those responsibilities. [IAS 37.10]. Say, for example, that an entity has previously
paid discretionary bonuses to policyholders in the past five years of 5%, 15%, 0%, 10%
and 5%. What ‘valid expectation’ has it created at the reporting date to policyholders in
the absence of any public statement of management intent or, say, a published policy
that discretionary bonuses will be linked to a particular profit figure?
If a DPF does not meet the definition of a liability then, under IAS 32, it would default to
being equity, which is the residual interest in an entity’s assets after deduction of its
liabilities. This appears counter-intuitive and would result in discretionary distributions
to policyholders being recorded as equity transactions outside of profit or loss or other
comprehensive income. Taking this approach, a contract with a DPF would be bifurcated
between liability and equity components like a bond convertible into equity shares.
The IASB’s response to this difficult conceptual issue was to ignore it altogether in
IFRS 4 and permit entities a choice as to whether to present contracts with a DPF within
liabilities or equity. The IASB considered that the factor making it difficult to determine
the appropriate accounting for these features is ‘constrained discretion’, being the
combination of discretion and constraints on that discretion. If participation features
lack discretion they are embedded derivatives and are within the scope of IAS 39 or
IFRS 9. [IFRS 4.BC161].
Insurance contracts (IFRS 4) 4319
There may be timing differences between accumulated profits under IFRS and
distributable surplus (i.e. the accumulated amount that is contractually eligible for
distribution to holders of a DPF), for example, because distributable surplus excludes
unrealised investment gains that are recognised under IAS 39 or IFRS 9. IFRS 4 does
not address the classification of such timing differences. [IFRS 4.BC160].
In November 2005, the Interpretations Committee rejected a request for further
interpretative guidance on the definition of a DPF. The Interpretations Committee
had been informed of concerns that a narrow interpretation of a DPF would fail to
ensure clear and comprehensive disclosure about contracts that included these
features. In response, the Interpretations Committee noted that disclosure was
particularly important in this area, drawing attention to the related implementation
guidance, discussed at 10 below, but declined to add the topic to its agenda because it
involved some of the most difficult questions that the IASB would need to resolve in
what became IFRS 17.4
In January 2010, the Interpretations Committee also rejected a request to provide
guidance on whether features contained in ownership units issued by certain Real Estate
Investment Trusts (REITs) met the definition of a DPF. In some of the trusts, the
contractual terms of the ownership units require the REIT to distribute 90% of the Total
Distributable Income (TDI) to investors. The remaining 10% may be distributed at the
discretion of management. The request was to provide guidance on whether the
discretion to distribute the remaining 10% of TDI met the definition of a DPF. If so,
IFRS 4 would permit the ownership units to be classified as a liability in its entirety
rather than a compound instrument with financial liability and equity components under
IAS 32. The Interpretations Committee noted that the definition of a DPF in IFRS 4
requires, among other things, that the instrument provides the holder with guaranteed
benefits and that the DPF benefits are in addition to these guaranteed benefits.
Furthermore, it noted that such guaranteed benefits were typically found in insurance
contracts. In other words, the Interpretations Committee was very sceptical about this
presentation. However, it considered that providing guidance on this issue would be in
the nature of application rather than interpretive guidance and therefore declined to
add the issue to its agenda.5
The lack of interpretative guidance as to what constitutes a DPF has led to diversity in
practice as to what is recognised as a DPF liability. For example, IFRS 4 is silent as to
whether that part of an undistributed surplus on a participating contract which does not
belong to policyholders should be treated as a liability or equity. This is illustrated by
the following example.
Example 51.29: DPF recognition
A minimum of 90% of an investment surplus on a participating contract may be distributed to policyholders
although any distribution is entirely at the discretion of the insurer. However, IFRS 4 is silent as to whether
the 10% of the surplus which does not belong to policyholders is part of the DPF if it has not been distributed
and consequentially there is diversity in practice among insurers as to whether the undistributed DPF liability
includes the amount attributable to shareholders. Some insurers recognise the 90% as
a liability and the 10%
as a component of equity whereas others recognise the entire 100% as a liability until it is distributed.
4320 Chapter 51
6.1
Discretionary participation features in insurance contracts
Whilst IFRS 4 permits previous accounting practices for insurance contracts (see 7
below), the IASB considered there was a need to specify special accounting
requirements for DPF features within these contracts. This might seem odd but the
IASB’s main concerns were:
• to prevent insurers classifying contracts with a DPF as an intermediate category
that is neither liability nor equity as may have been permitted under some existing
local accounting practices, such an intermediate category being incompatible with
the Framework; [IFRS 4.BC157] and
• to ensure consistency with the treatment of DPF in investment contracts. [IFRS 4.BC158].
IFRS 4 requires any guaranteed element (i.e. the obligation to pay guaranteed benefits
included in a contract that contains a DPF) within an insurance contract to be
recognised as a liability. However, insurers have an option as to whether to present a
DPF either as a liability or as a component of equity. The following requirements apply:
(a) where the guaranteed element is not recognised separately from the DPF the
whole contract must be classified as a liability;
(b) where the DPF is recognised separately from the guaranteed element the DPF can
be classified as either a liability or as equity. IFRS 4 does not specify how an insurer
determines whether the DPF is a liability or equity. The insurer may split the DPF
into liability and equity components but must use a consistent accounting policy
for such a split; and
(c) a DPF cannot be classified as an intermediate category that is neither liability nor
equity. [IFRS 4.34(a)-(b)].
An insurer may recognise all premiums received as revenue without separating any
portion that relates to the equity component. [IFRS 4.34(c)]. The use of the word ‘may’
means that an insurer can classify some of the DPF as equity but continue to record all
of the contract premiums as income. Conceptually, the IASB has admitted that if part or
all of the DPF is classified as a component of equity, then the related portion of the
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