FRS 103 Insurance Contracts – Consolidated accounting and reporting requirements for entities in the UK and Republic of Ireland issuing insurance contracts was issued by the Financial Reporting Council (FRC) in March 2014 as part of the new suite of standards which form new UK GAAP.
FRS 103 applies to financial statements which are prepared under the principles of FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and which are intended to give a true and fair view. FRS 103 applies to:
- Insurance contracts (including reinsurance contracts) that an entity issues and reinsurance contracts that it holds; and
- Financial instruments (other than insurance contracts) that it issues with a discretionary participation feature.
FRS 103 itself is only going to have a limited lifespan and the FRC expect to review the standard once the International Accounting Standards Board (IASB) has issued its updated standard on insurance contracts. The IASB have said that this is due to be published towards the end of 2016. This article looks primarily at the issues concerning insurers’ accounting policies under FRS 103.
There are certain aspects which FRS 103 does not deal with, which are outlined in the following table:
An insurer is allowed to change its accounting policies for insurance contracts if, and only if, the change makes the financial statements more relevant to the economic decision-making needs of the users and no less reliable, or more reliable and no less relevant to those needs. When an insurer is considering changing its accounting policies, it must justify how the change will bring its financial statements closer to meeting the criteria outlined in paragraph 10.4 of FRS 102. Paragraph 10.4 of FRS 102 requires that management develop accounting policies which results in information that is:
- Relevant to the economic decision-making needs of users; and
- Reliable, in that the financial statements:
- represent faithfully the financial position, financial performance and cash flows of the entity;
- reflect the economic substance of transactions, other events and conditions, and not merely the legal form;
- are neutral, i.e. free from bias;
- are prudent; and
- are complete in all material respects.
FRS 103 covers five specific issues as follows:
- Current interest rates;
- Continuation of existing practices;
- Future investment margins; and
- Shadow accounting.
Current market interest rates
Paragraph 2.5 of FRS 103 allows an insurer to change its accounting policies so that it remeasures designated insurance liabilities to reflect current market interest rates. Any changes to such liabilities are recognised in profit or loss. In addition, paragraph 2.5 also allows an insurer to change its accounting policies for designated liabilities without applying those policies consistently to all similar liabilities which would otherwise be required by Section 10 Accounting Policies, Estimates and Errors in FRS 102. Where an insurer designates liabilities for this election, the standard requires the insurer to apply current market interest rates (and, where applicable, the other current estimates and assumptions) consistently in all periods to such liabilities until they are extinguished.
Continuation of existing practices
FRS 103 allows an insurer to continue with the following practices:
- Unless otherwise required by the Regulations (or other legal framework that applies to the entity), measuring insurance liabilities on an undiscounted basis;
- Measuring contractual rights to future investment management fees at an amount which exceeds fair value as implied by a comparison with current fees charged by other market participants for similar services. Paragraph 2.6 recognises that 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; and
- Use non-uniform accounting policies for the insurance contracts (and related deferred acquisition costs and related intangible assets, if any) of subsidiaries, except as permitted by paragraph 2.5 of FRS 103. If those accounting policies are not uniform, the standard allows an insurer to change them if the change does not make the accounting policies more diverse and also satisfies other requirements in FRS 103.
FRS 103 does not require an insurer to change its accounting policies in respect of insurance contracts to eliminate excessive prudence. However, if the insurer already measures its insurance contracts with sufficient levels of prudence, the standard does not require additional prudence.
Future investment margins
Paragraph 2.8 does not require an insurer to change its accounting policies for insurance contracts to eliminate future investment margins. There is, however, a rebuttable presumption that an insurer’s financial statements will become less relevant and reliable if the insurer introduces an accounting policy that reflects future investment margins in the measurement of insurance contracts. There are two examples of accounting policies which reflect those margins:
- Using a discount rate which reflects the estimated return on the insurer’s assets; or
- 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.
If the Regulations permit, an insurer can overcome the rebuttable presumption described above if, and only if, the other components of a change in accounting policies increase the relevance and reliability of its financial statements sufficiently enough to outweigh the decrease in relevance and reliability caused by the inclusion of future investment margins. Paragraph 2.9 cites an example of an insurer whose existing accounting policies for insurance contracts involve excessively prudent assumptions that are set at the inception of the contract with a discount rate prescribed by a regulator without direct reference to market conditions and ignoring some embedded options and guarantees. The example suggests that the insurer may 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, although not excessively prudent, adjustment to reflect risk and uncertainty;
- Measurements which 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 insurer’s assets.
Some insurers may use the discount rate to determine the present value of a future profit margin which is then attributed to different periods using a formula. This means that the discount rate affects the measurement of the liability only indirectly and the use of a less appropriate discount rate has a limited or no effect on the measurement of the liability at inception. However, in some other approaches, the discount rate determines the measurement of the liability directly and in this case it is unlikely that the insurer could overcome the rebuttable presumption described above.
Often realised gains or losses on an insurer’s assets will have a direct effect on the measurement of some, or all, of the insurer’s:
- Insurance liabilities;
- Related deferred acquisition costs; and
- Related intangible assets.
FRS 103 allows (but does not require) the insurer to change its accounting policies in such a way that an unrecognised gain or loss on an asset affects those measurements in the same way as a realised gain or loss. When the insurer applies this method, any adjustment to the insurance liability, deferred acquisition costs or intangible assets is recognised in other comprehensive income if, and only if, the unrealised gains or losses are recognised in other comprehensive income. This practice is described as ‘shadow accounting’.
Exemptions from FRS 102
FRS 102 at paragraphs 10.4 to 10.6 outlines how an entity’s management is to use its judgement in developing and applying an accounting policy when an FRS or an FRC Abstract does not deal with a transaction, event or condition. FRS 103 exempts an insurer from these paragraphs in FRS 102 in relation to its accounting policies for:
- Insurance contracts that it issues, which also includes acquisition costs and related intangible assets; and
- Reinsurance contracts which it holds.
Whilst paragraph 2.12 does not require an insurer to follow those paragraphs in FRS 102, paragraph 2.13 specifically requires an insurer to:
- Not recognise any liabilities in respect of possible future claims if the claims do not arise from insurance contracts which did not exist at the end of the reporting period;
- Carry out a liability adequacy test;
- Remove an insurance liability (or part thereof) when, and only when, it is extinguished;
- Not offset reinsurance assets against related insurance liabilities or income or expense from reinsurance contracts against the expense or income from the related contracts; and
- Consider whether reinsurance assets are impaired.
In respect of the liability adequacy test noted above; an insurer has to undertake an assessment at the end of each reporting period to assess whether its recognised insurance liabilities are adequate. The insurer uses current estimates of future cash flows under its insurance contacts for the purposes of this test. If the test reveals that the carrying amount of the insurer’s liabilities (less related deferred acquisition costs and related intangible assets) is inadequate in light of the estimated future cash flows, the entire deficiency must be recognised in profit or loss.
Recent amendments to FRS 103
In May 2016, the FRC issued amendments to FRS 103 to reflect the implementation of the Solvency II Directive from 1 January 2016. The amendments update the terminology and definitions used for changes in the regulatory framework following the implementation of the Solvency II Directive. It should be noted that these amendments do not require any changes to insurers’ established accounting practices which can continue to be applied if the entity so chooses.
AAT members and Licensed Accountants that prepare financial statements for insurers will need to have a sound understanding of the requirements in FRS 103. It is also important to bear in mind that FRS 103 will only have a limited lifespan and therefore accountants should keep abreast of developments in this area on the FRC’s website so as to be kept up to date on revisions to the standard.
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Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.