[IFRS 4.BC142].
In addition, where embedded values are generally determined on a single best estimate
basis, the IASB considers that they do not reflect a full range of possible outcomes and
do not generally adequately address liabilities arising from embedded guarantees and
options. Further, the IASB believes that existing embedded value approaches are largely
unregulated and there is diversity in their application. [IFRS 4.BC141].
It is possible for insurers to introduce accounting policies that use an embedded value
approach even if that involves the use of asset-based discount rates for liabilities if they
can overcome the rebuttable presumption described above. This will be if, and only 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. For example,
suppose an insurer’s existing accounting policies for insurance contracts involves
excessively prudent assumptions set at inception and a discount rate prescribed by a
regulator without direct reference to market conditions, and the assumptions ignore
some embedded options and guarantees. The insurer might make its financial
statements more relevant and no less reliable by switching to a basis of accounting that
is widely used and involves:
(a) current estimates and assumptions;
(b) a reasonable (but not excessively prudent) adjustment to reflect risk and uncertainty;
(c) measurements that reflect both the intrinsic value and time value of embedded
options and guarantees; and
(d) a current market discount rate, even if that discount rate reflects the estimated
return on the insurer’s assets. [IFRS 4.28].
In some measurement approaches, the discount rate is used to determine the present
value of a future profit margin. That profit margin is then attributed to different periods
using a formula. In those approaches, the discount rate affects the measurement of the
liability only indirectly. In these circumstances, the IASB has concluded that the use of
a less appropriate discount rate has a limited or no effect on the measurement of the
liability at inception. However, in other approaches, the IASB considers that the
discount rate determines the measurement of the liability directly. In the latter case,
because the introduction of an asset-based discount rate has a more significant effect,
the IASB believes that it is highly unlikely that an insurer could overcome the rebuttable
presumption described above. [IFRS 4.29].
The IASB believes that in most applications of embedded value the discount rate
determines the measurement of the liability directly and therefore it is highly unlikely
that an insurer could overcome the rebuttable presumption described above if it wanted
to change its accounting policies for insurance contracts to an embedded value basis.
[IFRS 4.BC144].
4342 Chapter 51
8.3 Shadow
accounting
IFRS 4 grants relief to insurers allowing them to mitigate an accounting mismatch
occurring when unrealised gains or losses on assets backing insurance contracts affect
the measurement of the insurance contracts. This relief, known as ‘shadow accounting’,
ensures that all gains and losses on investments affect the measurement of the insurance
assets and liabilities in the same way, regardless of whether they are realised or
unrealised and regardless of whether the unrealised investment gains and losses are
recognised in profit or loss or in other comprehensive income using a revaluation
reserve. In particular, the relief permits certain gains or losses arising from remeasuring
insurance contracts to be recognised in other comprehensive income whereas IFRS 4
otherwise requires all gains and losses arising from insurance contracts to be recognised
in profit or loss. Normally, this change in accounting policy would be adopted upon
transition to IFRS. Application of shadow accounting is always voluntary and in practice
it is also applied selectively.
In many local GAAP accounting models, gains or losses on an insurer’s assets have a
direct effect on the measurement of some or all of its insurance liabilities, related
deferred acquisition costs and related intangible assets. [IFRS 4.30]. In some of these
models, prior to the introduction of IFRS, the insurer’s assets were measured at cost or
amortised cost and unrealised fair value movements were not recognised. Under IFRS,
most of an insurer’s assets are likely to be held at either fair value through profit or loss
or available-for-sale with unrealised fair value gains recognised in profit or loss or other
comprehensive income respectively. If the unrealised gains on the insurance liabilities
(or deferred acquisition costs and intangible assets) which the assets back were not also
recognised there would be an accounting mismatch.
The IASB believe that, in principle, gains or losses on an asset should not influence the
measurement of an insurance liability unless the gains or losses on the asset alter the
amounts payable to policyholders. Nevertheless, this was a feature of some existing
measurement models for insurance liabilities and the IASB decided that it was not
feasible to eliminate this practice. The IASB also acknowledged that shadow accounting
might mitigate volatility caused by differences between the measurement basis for
assets and the measurement basis for insurance liabilities. However, that is a by-product
of shadow accounting and not its primary purpose. [IFRS 4.BC183].
IFRS 4 permits, but does not require, a change in accounting policies so that a
recognised but unrealised gain or loss on an asset affects the related insurance liabilities
in the same way that a realised gain or loss does. In other words, a measurement
adjustment to an insurance liability (or deferred acquisition cost or intangible asset)
arising from the remeasurement of an asset would be recognised in other
comprehensive income if, and only if, the unrealised gains or losses on the asset are also
recognised in other comprehensive income. [IFRS 4.30].
Recognition of movements in insurance liabilities (or deferred acquisition costs or
intangible assets) in other comprehensive income only applies when unrealised gains on
assets are recognised in other comprehensive income such as for available-for-sale
investments accounted for under IAS 39, debt or equity securities classified at fair value
through other comprehensive income under IFRS 9 or property, plant and equipment
accounted for using the revaluation model under IAS 16. [IFRS 4.IG10].
Insurance contracts (IFRS 4) 4343
Shadow accounting is not applicable for liabilities arising from investment contracts
accounted for under IAS 39 or IFRS 9. However, shadow accounting may be applicable
for a DPF within an investment contract if the measurement of that feature depends on
asset values or asset returns. [IFRS 4.IG8].
Further, shadow accounting may not be used if the measurement of an insurance
liability is not driven by realised gains and losses on assets held, for example if the
insurance liabilities are measured using a discount rate that
reflects a current market
rate but that measurement does not depend directly on the carrying amount of any
assets held. [IFRS 4.IG9].
The implementation guidance to IFRS 4 includes an illustrative example to show how
shadow accounting through other comprehensive income might be applied. This
example is reproduced in full below.
Example 51.31: Shadow accounting
Background
Under some national requirements for some insurance contracts, deferred acquisition costs (DAC) are
amortised over the life of the contract as a constant proportion of estimated gross profits (EGP). EGP includes
investment returns, including realised (but not unrealised) gains and losses. Interest is applied to both DAC
and EGP, to preserve present value relationships. For simplicity, this example ignores interest and ignores re-
estimation of EGP.
At the inception of a contract, insurer A has DAC of CU20 relating to that contract and the present value, at
inception, of EGP is CU100. In other words, DAC is 20 per cent of EGP at inception. Thus, for each CU1 of
realised gross profits, insurer A amortises DAC by CU0.20. For example, if insurer A sells assets and
recognises a gain of CU10, insurer A amortises DAC by CU2 (20 per cent of CU10).
Before adopting IFRSs for the first time in 2013, insurer A measured financial assets on a cost basis.
(Therefore, EGP under those national requirements considers only realised gains and losses.) However, under
IFRSs, it does not apply IFRS 9 and classifies its financial assets as available for sale. Thus, insurer A
measures the assets at fair value and recognises changes in their fair value directly in other comprehensive
income. In 2013, insurer A recognises unrealised gains of CU10 on the assets backing the contract.
In 2014, insurer A sells the assets for an amount equal to their fair value at the end of 2013 and, to comply
with IAS 39, transfers the now-realised gain of CU10 from other comprehensive income to profit or loss.
Application of paragraph 30 of IFRS 4
Paragraph 30 of IFRS 4 permits, but does not require, insurer A to adopt shadow accounting. If insurer A
adopts shadow accounting, it amortises DAC in 2013 by an additional CU2 (20 per cent of CU10) as a result
of the change in the fair value of the assets. Because insurer A recognised the change in the assets’ fair value
in other comprehensive income, it recognises the additional amortisation of CU2 directly in other
comprehensive income.
When insurer A sells the assets in 2014, it makes no further adjustment to DAC, but transfers DAC
amortisation of CU2 relating to the now-realised gain from other comprehensive income to profit or loss.
In summary, shadow accounting treats an unrealised gain in the same way as a realised gain, except that the
unrealised gain and resulting DAC amortisation are (a) recognised in other comprehensive income rather than
in profit or loss and (b) transferred to profit or loss when the gain on the asset becomes realised.
If insurer A does not adopt shadow accounting, unrealised gains on assets do not affect the amortisation of
DAC (i.e. the CU2 of DAC amortisation would have been recognised in profit or loss in 2013).
[IFRS 4.IG10, IE4].
4344 Chapter 51
Old Mutual is an example of an entity that applies shadow accounting.
Extract 51.10: Old Mutual plc (2016)
Notes to the consolidated financial statements [extract]
G: Analysis of financial assets and liabilities [extract]
G6: Insurance and investment contracts [extract]
Insurance contract liabilities [extract]
In respect of the South Africa life assurance, shadow accounting is applied to insurance contract liabilities where the
underlying measurement of the policyholder liability depends directly on the value of owner-occupied property and
the unrealised gains and losses on such property, which are recognised in other comprehensive income. The shadow
accounting adjustment to insurance contract liabilities is recognised in other comprehensive income to the extent that
the unrealised gains or losses on owner-occupied property backing insurance contract liabilities are also recognised
directly in other comprehensive income.
IFRS 4 does not specifically address the interaction between shadow accounting and
the liability adequacy test. We believe that shadow accounting is applied before the
liability adequacy test and the implications of this are discussed at 7.2.2.D above.
8.4
Redesignation of financial assets
IAS 39 generally prohibits the reclassification of a financial asset into the ‘fair value
through profit or loss’ category while it is held or issued. [IAS 39.50]. IFRS 9 allows such
reclassifications only when an entity changes its business model for financial assets.
[IFRS 9.4.4.1]. However, when an insurer changes its accounting policies for insurance
liabilities, it is permitted, but not required, to reclassify some or all of its financial assets
at fair value through profit or loss. This reclassification is permitted if an insurer changes
its accounting policies when it first applies IFRS 4 and also if it makes a subsequent
policy change permitted by IFRS 4. This reclassification is a change in accounting policy
and the requirements of IAS 8 apply, i.e. it must be performed retrospectively unless
impracticable. [IFRS 4.45, IAS 39.50A(c)].
The IASB decided to grant this exemption from IAS 39 or IFRS 9 in order to allow an
insurer to avoid an accounting mismatch when it improves its accounting policies for
insurance contracts and to remove unnecessary barriers for insurers wishing to move to
a measurement basis that reflects fair values. [IFRS 4.BC145].
This concession cannot be used to reclassify financial assets out of the fair value through
profit or loss category. These remain subject to the normal IAS 39 or IFRS 9 requirements.
8.5 Practical
issues
8.5.1
Changes to local GAAP
As most entities are applying some form of local GAAP for their insurance contracts
under IFRS 4, a common issue is whether an entity is obliged to change its accounting
policy when local GAAP changes or whether the decision to change accounting policy
for IFRS purposes is one that remains solely with the insurer.
Insurance contracts (IFRS 4) 4345
In our view, the decision to change an accounting policy established on the initial
adoption of IFRS is at the discretion of the entity. Accordingly, any change in local
GAAP for insurance contracts that was used as the basis for the initial adoption of IFRS
does not oblige the insurer to change its accounting policies.
Although an entity is not required to change its policies when local GAAP changes, it
can make voluntary changes provided the revised accounting policy makes the financial
statements more relevant and no less reliable or more reliable and no less relevant, as
discussed at 8.1 above.
When a local accounting standard is changed, it is likely that the change is made for a
reason. Therefore, there would normally be a rebuttable presumption that any change
in local GAAP is an improvement to the existing standard and so is more relevant and
no less reliable or more reliable and no less relevant to users than the previous standard
would have been.
The fact that an entity can decide whether or no
t to apply changes in local GAAP has,
over time, led to further diversity in practice.
An entity should not state that it fully applies a particular local GAAP for insurance
contracts if it no longer complies with that GAAP due to it not implementing a local
GAAP accounting policy change.
9
INSURANCE CONTRACTS ACQUIRED IN BUSINESS
COMBINATIONS AND PORTFOLIO TRANSFERS
9.1
Expanded presentation of insurance contracts
IFRS 3 requires most assets and liabilities, including insurance liabilities assumed and
insurance assets acquired, in a business combination to be measured at fair value.
[IFRS 4.31]. The IASB saw no compelling reason to exempt insurers from these
requirements. [IFRS 4.BC153].
However, an insurer is permitted, but not required, to use an expanded presentation
that splits the fair value of acquired insurance contracts into two components:
(a) a liability measured in accordance with the acquirer’s accounting policies for
insurance contracts that it issues; and
(b) an intangible asset, representing the difference between (i) the fair value of the
contractual insurance rights acquired and insurance obligations assumed and (ii)
the amount described in (a). The subsequent measurement of this asset should be
consistent with the measurement of the related insurance liabilities. [IFRS 4.31(a), (b)].
We note that technically this IFRS 4 intangible has no intrinsic value that can be
actuarially calculated. It is no more than the balancing number between the purchase
price allocated to the insurance liability and the amount recorded for the insurance
liability by the purchaser under the purchaser’s existing GAAP. The more prudent
(higher) the basis of liability measurement, the higher the value of the intangible.
4346 Chapter 51
This alternative presentation had often been used in practice under many local GAAPs.
Life insurers have variously described this intangible asset as the ‘present value of in-
force business’ (PVIF), ‘present value of future profits’ (PVFP or PVP) or ‘value of
business acquired’ (VOBA). Similar principles apply in non-life insurance, for example,
if claims liabilities are not discounted. [IFRS 4.BC147].
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 860
