Reserving actuaries are, basically, experts in handling one really big liability – what insurers owe on the contracts they’ve underwritten. So when the International Accounting Standards Board (IASB) posts an exposure draft on standards for reporting insurance contracts, it’s big news in the worldwide actuarial community.
The issue also resonates in the United States, as our Financial Accounting Standards Board (FASB) helped devise the standard, and supports most parts of it.
The boards also recognized – in a departure from previous work – that property/casualty insurance is not as long-tailed or complex as life insurance, so its contracts can usually conform to a simpler model. So most of what follows would mainly affect life insurance.
The proposal breaks an insurance contract down to four building blocks, shown in this picture from IASB materials:
- The largest block is the present value of all expected cash flows, both in and out.
- The next adjustment is a margin for the time value of money – basically the amount attributable to the process of discounting.
- Third is a risk adjustment – basically reflecting the extra amount an insurer would have to pay to be relieved of the risk.
- Fourth is the difference between the first three items and the amount charged for the policy. You might call it the expected profit. IASB calls it the residual margin.
On the first day of the contract, all four building blocks would be booked. The sum of the four would equal the insurance premium. As time passed, each of the amounts would move up or down, releasing the residual margin (profits) over the life of the contract and releasing the other margins as the volatility of the contract wound down.
IASB offered another illustrated example showing how profits would be released. Note that the colors used in the second graphic correspond to the building blocks in the first graphic:
Here a $20 liability was established when the policy was written. During the year, a bunch of stuff happened:
There were $5 of expected cash flows.
And there was some good news: The riskiness of the liability decreased over time, so $3 of the risk adjustment was released to profit. And $1 of the residual margin (i.e., profit) was recognized.
But there was more. As the due date for more liabilities draws near, the present value of them increases. (Sometimes this is called the unwinding of the discount.) That means the liability grows, in this case by $2. Finally, another $1 of payments were not expected, so the liability for the entire contract grew by $1.
Overall, the liability shrank from $20 to $14. Items affecting profit and loss are in the gray box and the sum of them [(-3) + (-1) + 2 + 1)] gives you the profit in the period, $1.
FASB, the U.S. board, agrees with this approach, though it combines the risk margin and the residual margin, calling the sum of them the composite margin.
This seems to be a big improvement over IASB’s original proposal, which required contracts to be valued on their exit price. The exit price depended on the market value of the contract, but since there’s no real secondary market for insurance liabilities, that wasn’t much help.
Now IASB talks about the fulfillment approach – the amount of money needed for the insurer to fulfill its obligations under a contract. This way, internal measures of the contract take place of the market measures of the contract (which never really existed anyway.)
The fulfillment approach has another big advantage. It doesn’t allow profits to be booked on the day a policy was written.
Consider a $100 policy written today with an exit value of $75 (assuming one can be measured). The expected profit is $25.
Under the exit price standard, that profit would be recognized on the day the policy was written. So a company would be allowed to recognize profits on a policy before seeing how it performed. That didn’t seem right. (Under current U.S. accounting, the profit is recognized over the life of the policy.)
Now, the residual margin is recognized over the contract term, and the risk margin turns to profit as the risk of the policy diminishes.
The proposal is at the exposure draft stage. Comments are encouraged through Nov. 30. Implementation is targeted for the middle of next year.