BADVAC3X – GOVERNMENT AND NOT-FOR-PROFIT ACCOUNTING

MODULE 5: SPECIAL TOPICS

PART I. INSURANCE CONTRACTS (PFRS 17)

Overview of Insurance Companies

The primary function of insurance companies is to protect individuals and corporations (policyholders) from adverse
events. By accepting premiums, insurance companies promise policyholders compensation if certain specified events
occur. These policies represent financial liabilities to the insurance company. With the premiums collected, insurance
companies invest in financial securities such as corporate bonds and stocks. The industry is classified into two major
groups: life and property–casualty

Life insurance provides protection against the possibility of untimely death, illnesses, and retirement. Property insurance
protects against personal injury and liability such as accidents, theft, and fire. However, as will become clear, insurance
companies also sell a variety of investment products in a similar fashion to other financial service firms, such as mutual
funds and depository institutions.

Life Insurance

Life insurance allows individuals and their beneficiaries to protect against losses in income through premature death or
retirement. By pooling risks, life insurance transfers income-related uncertainties from the insured individual to a group.

Exhibit 1. Top ten life insurance companies in the Philippines (based on premiums).

While life insurance may be the core activity area, modern life insurance companies also sell annuity contracts, manage
pension plans, and provide accident and health insurance.

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One problem that naturally faces life insurance companies (as well as property– casualty insurers) is the so-called
adverse selection problem. Adverse selection is a problem in that customers who apply for insurance policies are more
likely to be those most in need of insurance (i.e., someone with chronic health problems is more likely to purchase a life
insurance policy than someone in perfect health).

As the various types of insurance policies and services offered are described below, notice that some policies (such as
universal life policies and annuities) provide not only insurance features but also savings components. For example,
universal life policy payouts are a function of the interest earned on the investment of the policyholder’s premiums.

Types of Life Insurance

The four basic classes or lines of life insurance are distinguished by the manner in which they are sold or marketed to
purchasers. These classes are (1) ordinary life, (2) group life, (3) industrial life, and (4) credit life. Majority of the
customers purchase ordinary life insurance.

Ordinary Life. Ordinary life insurance involves policies marketed on an individual basis, on which policyholders make
periodic premium payments. Despite the enormous variety of contractual forms, there are essentially five basic
contractual types.

• Term life. A term life policy is the closest to pure life insurance, with no savings element attached. Essentially,
the individual receives a payout contingent on death during the coverage period. The term of coverage can vary
from as little as 1 year to 40 years or more.
• Whole life. A whole life policy protects the individual over an entire lifetime. In return for periodic or level
premiums, the individual’s beneficiaries receive the face value of the life insurance contract on death. Thus, there
is certainty that if the policyholder continues to make premium payments, the insurance company will make a
payment—unlike term insurance. As a result, whole life has a savings element as well as a pure insurance
element.
• Endowment life. An endowment life policy combines a pure (term) insurance element with a savings element.
It guarantees a payout to the beneficiaries of the policy if death occurs during some endowment period (e.g.,
prior to reaching retirement age). An insured person who lives to the endowment date receives the face amount
of the policy.
• Variable life. Unlike traditional policies that promise to pay the insured the fixed or face amount of a policy if a
contingency arises, variable life insurance invests fixed premium payments in mutual funds of stocks, bonds, and
money market instruments. Usually, policyholders can choose mutual fund investments to reflect their risk
preferences. Thus, variable life provides an alternative way to build savings compared with the more traditional
policies such as whole life because the value of the policy increases or decreases with the asset returns of the
mutual fund in which the premiums are invested.
• Universal life and variable universal life. Universal life allows both the premium amounts and the maturity
of the life contract to be changed by the insured, unlike traditional policies that maintain premiums at a given
level over a fixed contract period. In addition, for some contracts, insurers invest premiums in money, equity, or
bond mutual funds—as in variable life insurance—so that the savings or investment component of the contract
reflects market returns. In this case, the policy is called variable universal life.

Group Life. Insurance Group life insurance covers a large number of insured persons under a single policy. Usually
issued to corporate employers, these policies may be either contributory (where both the employer and employee cover a
share of the employee’s cost of the insurance) or noncontributory (where the employee does not contribute to the cost of
the insurance) for the employees. Cost economies represent the principal advantage of group life over ordinary life
policies. Cost economies result from mass administration of plans, lower costs for evaluating individuals through medical
screening and other rating systems, and reduced selling and commission costs.

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Industrial Life. Industrial life insurance currently represents a very small area of coverage. Industrial life usually
involves weekly payments directly collected by representatives of the companies. To a large extent, the growth of group
life insurance has led to the demise of industrial life as a major activity class.

Credit Life. Credit life insurance is sold to protect lenders against a borrower’s death prior to the repayment of a debt
contract such as a mortgage or car loan. Usually, the face amount of the insurance policy reflects the outstanding
principal and interest on the loan.

Other Life Insurer Activities

Annuities. Annuities represent the reverse of life insurance activities. Whereas life insurance involves different
contractual methods of building up a fund, annuities involve different methods of liquidating a fund, such as paying out a
fund’s proceeds.

Private Pension Funds. Insurance companies offer many alternative pension plans to private employers in an effort to
attract this business from other financial service companies, such as commercial banks and security firms.

Accident and Health Insurance. While life insurance protects against mortality risk, accident and health insurance
protect against morbidity, or ill health, risk. The major activity line is group insurance, providing health insurance
coverage to corporate employees.

Balance Sheet

Because of the long-term nature of their liabilities (as a result of the long-term nature of life insurance policyholders’
claims) and the need to generate competitive returns on the savings elements of life insurance products, life insurance
companies concentrate their asset investments at the longer end of the maturity spectrum (e.g., bonds, equities, and
government securities).

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 Selected assets and liabilities definition

Policy Loans made by an insurance

company to its policyholders using their
policies as collateral (Asset).

Surrender value of a policy. The cash value

of a policy received from the insurer if a
policyholder surrenders the policy before
maturity. The cash surrender value is
normally only a portion of the contract’s
face value.

Exhibit 2. Balance sheet of Life Insurance Company (AIA Philamlife Insurance Company)

Non-Life Insurance (Property and Casualty)

Property insurance involves insurance coverages related to the loss of real and personal property. Casualty—or, perhaps
more accurately, liability—insurance concerns protection against legal liability exposures. However, the distinctions
between the two broad areas of property and liability insurance are increasingly becoming blurred. This is due to the
tendency of PC insurers to offer multiple activity line coverages combining features of property and liability insurance
into single policy packages, for example, homeowners multiple-peril insurance.

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Exhibit 3. Top Non-Life Insurance Companies in the Philippines (based on premiums written)

Types of Property-Casualty Insurance

Fire insurance and allied lines. Protects against the perils of fire, lightning, and removal of property damaged in a fire

Homeowners multiple-peril (MP) insurance. Protects against multiple perils of damage to a personal dwelling and
personal property as well as providing liability coverage against the financial consequences of legal liability due to injury
done to others.

Commercial multiple-peril insurance. Protects commercial firms against perils; similar to homeowners multiple-peril
insurance.

Automobile liability and physical damage (PD) insurance. Provides protection against (1) losses resulting from
legal liability due to the ownership or use of the vehicle (auto liability) and (2) theft of or damage to vehicles (auto
physical damage)

Liability insurance (other than auto). Provides either individuals or commercial firms with protection against non-
automobile-related legal liability. For commercial firms, this includes protection against liabilities relating to their business
operations (other than personal injury to employees covered by workers’ compensation insurance) and product liability
hazards.

Balance Sheet

The balance sheet of a PC firm is shown below. Similar to life insurance companies, PC insurers invest the majority of
their assets in long-term securities, thus subjecting them to credit and interest rate risks. PC insurers hold mainly long-
term securities for two reasons. First, PC insurers, like life insurers, hold long-term assets to match the maturity of their
longer-term contractual liabilities. Second, PC insurers, unlike life insurers, have more uncertain payouts on their

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insurance contracts (i.e., they incur greater levels of liquidity risk). Thus, their asset structure includes many assets with
relatively fixed returns that can be liquidated easily and at low cost.

Exhibit 4. Balance sheet of a Non-life insurance company (Malayan Insurance)

Other Categories of Assets and Liabilties

As mentioned, largest portion of assets for insurance companies are investment in the form of financial instruments
(government securities, bonds, stocks, mutual funds)

Another asset category is reinsurance recoverables. These are amounts due from the company’s reinsurers. (Reinsurers
are insurance companies that insure other insurance companies, thus sharing the risk of loss.)

Liabilities, or claims against assets, are divided into two components: reserves for obligations to policyholders and claims
by other creditors. Reserves for an insurer’s obligations to its policyholders are by far the largest liability.
Property/casualty insurers have three types of reserve: unearned premium reserves, or liability for unexpired insurance
coverage; loss and loss adjustment reserves, or post claims liability; and other.

Unearned premiums are the portion of the premium that corresponds to the unexpired part of the policy period.
Premiums have not been fully “earned” by the insurance company until the policy expires. In theory, the unearned
premium reserve represents the amount that the company would owe all its policyholders for coverage not yet provided

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if one day the company suddenly went out of business or the policyholders cancel coverage. If a policy is canceled before
it expires, part of the original premium payment must be returned to the policyholder.

Loss reserves are obligations that an insurance company has incurred–from claims that have been or will be filed on
the exposures the insurer protected. Loss adjustment reserves are reserves set aside to pay for claims adjusters, legal
assistance, investigators and other expenses associated with settling claims. Property/casualty insurers set up claim
reserves only for accidents and other events that have happened.

Some claims, like fire losses, are easily estimated and quickly settled. But others, such as products liability and some
workers compensation claims, may be settled long after the policy has expired. The most difficult to assess are loss
reserves for events that have already happened but have not been reported to the insurance company, known as
"incurred but not reported" (IBNR). Examples of IBNR losses are cases where workers inhaled asbestos fibers but did not
file a claim until their illness was diagnosed 20 or 30 years later. Actuarial estimates of the amounts that will be paid on
outstanding claims must be made so that profit on the business can be calculated. Insurers estimate claims costs,
including IBNR claims, based on their experience. Reserves are adjusted, with a corresponding impact on earnings, in
subsequent years as each case develops and more details become known.

Revenues and Expenses

Policyholder premiums are an insurer’s main revenue source. When a property/casualty policy is issued, the unearned
premium is equal to the written premium. (Written premiums are the premiums charged for coverage under policies
written regardless of whether they have been collected or “earned.” Each day the policy remains in force, one day of
unearned premium is earned, and the unearned premium is reduced by the amount earned. For example, if a customer
pays $365 for a one-year policy starting January 1, the initial unearned premium reserve would be $365, and the earned
premium would be $0. After one day, the unearned premium reserve would be $364, and the earned premium would be
$1.

Under GAAP, policy acquisition expenses, such as agent commissions, are deferred and expensed on a ratable basis
generally in line with earning of premiums. As a result, under GAAP (and assuming losses and other expenses are
experienced as contemplated in the rate applied to calculate the premium) profit is generated steadily throughout the
duration of the contract. In contrast, under SAP expenses associated with the acquisition of the policy are recognized as
an expense as soon as the policy is issued but premiums are earned throughout the policy period.

By recognizing acquisition expenses before the premium income is fully earned, an insurance company is required to
absorb those expenses in its policyholders’ surplus. This appears to reduce the surplus available at the inception of a
policy to pay unexpected claims under that policy. In effect, surplus calculated this accounting system requires an insurer
to have a larger safety margin in its policyholder surplus levels to be able to fulfill its obligation to those policyholders.

Features of IFRS 17

Objective

IFRS 17 Insurance Contracts establishes the principles for the recognition, measurement, presentation and disclosure of
Insurance contracts within the scope of the Standard. The objective of IFRS 17 is to ensure that an entity provides
relevant information that faithfully represents those contracts. This information gives a basis for users of financial
statements to assess the effect that insurance contracts have on the entity's financial position, financial performance and
cash flows.

Central to IFRS 17 is the General Measurement Model (GMM), which insurance firms will apply to determine the liabilities
for their long-term insurance contracts and short-term contracts in the post claims incurred period.

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Scope

An entity shall apply IFRS 17 Insurance Contracts to:

• Insurance contracts, including reinsurance contracts, it issues;

• Reinsurance contracts it holds; and
• Investment contracts with discretionary participation features it issues, provided the entity also issues insurance
contracts

Separating components from an insurance contract

An insurance contract may contain one or more components that would be within the scope of another standard if they
were separate contracts. For example, an insurance contract may include an investment component or a service
component (or both).

The standard provides the criteria to determine when a non-insurance component is distinct from the host insurance
contract.

An entity shall:

(a) Apply IFRS 9 Financial Instruments to determine whether there is an embedded derivative to be separated and, if
there is, how to account for such a derivative.

(b) Separate from a host insurance contract an investment component if, and only if, that investment component is
distinct. The entity shall apply IFRS 9 to account for the separated investment component.

(c) After performing the above steps, separate any promises to transfer distinct non-insurance goods or services. Such
promises are accounted under IFRS 15 Revenue from Contracts with Customers.

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Level of aggregation

IFRS 17 requires entities to identify portfolios of insurance contracts, which comprises contracts that are subject to
similar risks and managed together. Contracts within a product line would be expected to have similar risks and hence
would be expected to be in the same portfolio if they are managed together.

Each portfolio of insurance contracts issues shall be divided into a minimum of:

• A group of contracts that are onerous at initial recognition, if any;

• A group of contracts that at initial recognition have no significant possibility of becoming onerous subsequently, if
any; and
• A group of the remaining contracts in the portfolio, if any.

An entity is not permitted to include contracts issued more than one year apart in the same group.

If contracts within a portfolio would fall into different groups only because law or regulation specifically constrains the
entity's practical ability to set a different price or level of benefits for policyholders with different characteristics, the
entity may include those contracts in the same group.

Recognition

An entity shall recognise a group of insurance contracts it issues from the earliest of the following:

(a) the beginning of the coverage period of the group of contracts;

(b) the date when the first payment from a policyholder in the group becomes due; and

(b) the date when the first payment from a policyholder in the group becomes due; and

(c) for a group of onerous contracts, when the group becomes onerous.

Measurement

On initial recognition, an entity shall measure a group of insurance contracts at the total of:

(a) the fulfilment cash flows (“FCF”), which comprise:

(i) estimates of future cash flows;

(ii) an adjustment to reflect the time value of money (“TVM”) and the financial risks associated with the future
cash flows; and

(iii) a risk adjustment for non-financial risk

(b) the contractual service margin (“CSM”).

An entity shall include all the future cash flows within the boundary of each contract in the group. The entity may
estimate the future cash flows at a higher level of aggregation and then allocate the resulting fulfilment cash flows to
individual groups of contracts.

Contractual service margin

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The CSM represents the unearned profit of the group of insurance contracts that the entity will recognise as it provides
services in the future. This is measured on initial recognition of a group of insurance contracts at an amount that, unless
the group of contracts is onerous, results in no income or expenses arising from:

(a) the initial recognition of an amount for the FCF;

(b) the derecognition at that date of any asset or liability recognised for insurance acquisition cash flows; and

(c) any cash flows arising from the contracts in the group at that date.

Subsequent measurement

On subsequent measurement, the carrying amount of a group of insurance contracts at the end of each reporting period
shall be the sum of: [IFRS 17:40]

(a) the liability for remaining coverage comprising:

(i) the FCF related to future services and;

(ii) the CSM of the group at that date;

(b) the liability for incurred claims, comprising the FCF related to past service allocated to the group at that date.

PART II. SERVICE CONCESSION AGREEMENTS (IFRIC 12)

Scope

There are a wide variety of arrangements in operation globally whereby government or government agencies enter into
contractual service arrangements to attract private sector participation in the development, financing, operation and
maintenance of infrastructure for public services.

IFRIC 12 is concerned with the accounting by private sector operators for “public-to-private” service concession
arrangements (which are also know by a variety of other titles, including “service concession” “build-operate-transfer” or
“rehabilitate-operate-transfer” arrangements). These arrangements typically involve a private sector operator
constructing (or upgrading) the infrastructure used to provide the public service, and then operating and maintaining the
infrastructure for a specified period of time.

However, the Interpretation does not apply to all such arrangements. Its scope is limited to public-to-private service
concession arrangements in which:

• the grantor controls the use of the infrastructure; and

• the grantor controls (through ownership, beneficial entitlement or otherwise) any significant residual interest in the
infrastructure at the end of the term of the arrangement.

Controlling the use of the infrastructure

The grantor is considered to control the use of the infrastructure when it controls or regulates: the services to be
provided with the infrastructure; to whom those services must be provided; and the price to be charged for those
services.

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This control could be by contract or otherwise (e.g. through a regulator). The application guidance issued as part of the
Interpretation clarifies that it is not necessary that the grantor have complete control of the price – it is sufficient for the
prices to be regulated by the grantor, contract or regulator, for example by a capping mechanism. The condition is to be
applied to the substance of the agreement. Therefore, non-substantive features such as a cap that will apply only in
remote circumstances are ignored.

Significant residual interest

For this condition, the grantor’s control over any significant residual interest should both restrict the operator’s practical
ability to sell or pledge the infrastructure and give the grantor a continuing right of use throughout the period of the
arrangement. Where a significant residual interest will exist in the infrastructure at the end of the service concession
arrangement, that residual interest must revert to the grantor for the arrangement to be within the scope of the
Interpretation.

Note that arrangements where no significant residual interest exists at the end of the term (commonly called “whole-of-
life service concession arrangements”) are not excluded from the scope of the Interpretation. Where a whole-of-life
service concession arrangement satisfies the control criterion discussed above, the arrangement will be within the scope
of the Interpretation, irrespective of which party controls any remaining insignificant residual interest.

Accounting model

The key issue dealt with by the Interpretation is the accounting for the operator’s rights over the infrastructure.

The first principle established in IFRIC 12 is that, under arrangements meeting the ‘grantor control’ criteria discussed
above, the infrastructure should not be recognised as property, plant and equipment of the operator because the
operator does not control the use of the infrastructure. Rather, the right that the operator receives is the right to operate
the infrastructure for the purpose of providing the public service on behalf of the grantor. On the basis of the economic
benefits to which it is entitled under the arrangement, the operator must determine whether the nature of the asset it
receives is a financial asset or an intangible asset (or a mixture of both of these).

The requirements of IFRIC 12 regarding the nature of the asset to be recognised can be summarised as follows:

Operator’s rights Classification Examples

Unconditional, contractual right to receive cash
or other financial asset from or at the direction
of the grantor.
Contractual right to charge based on usage of
the services. Amounts to be received are
contingent on the extent that the public uses
the service.
Consideration received partly in the form of a
financial asset and partly in the form of an
intangible asset.
Financial asset • Operator receives a fixed amount from the
grantor over the term of the arrangement
• Operator has a right to charge users over
the term of the arrangement, but any
shortfall will be reimbursed by the grantor
Intangible • Operator has a right to charge users over
asset the term of the arrangement
• Operator has a right to charge the grantor
based on usage of the services over the
term of the arrangement
Financial and • Operator receives a fixed amount from the
intangible grantor and a right to charge users over
components the term of the arrangement.

Financial asset

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A typical arrangement falling into this category is where an operator constructs or upgrades the infrastructure, and is
permitted to operate it for a fixed period of time for an agreed revenue stream to be received during the period of
operation.

Revenue and costs relating to the construction or upgrade are recognised in income over the construction phase of the
arrangement in accordance with IAS 11 Construction Contracts. Therefore, subject to the requirements of IAS 11, costs
are recognised by reference to the stage of completion of the construction project. Contract revenue is the fair value of
the amount due from the grantor for the construction activity – which may be in practice be measured as the fair value
of the asset under construction at the end of each reporting period, less amounts recognised as revenue in earlier
periods.

The construction revenue recognised to date is recognised as a financial asset. The financial asset is accounted for in
accordance with the requirements of IAS 39 Financial Instruments: Recognition and Measurement as:

• a loan or receivable; or

• an available-for-sale financial asset; or

• if so designated upon initial recognition, a financial asset at fair value through profit or loss, if the conditions for that
classification are met.

If the financial asset is accounted for either as a loan or receivable, or as an available-for-sale financial asset, IAS 39
requires interest calculated using the effective interest method to be recognised in profit or loss.

Intangible asset

A typical arrangement falling into this category is where the operator constructs or upgrades the infrastructure, and is
permitted to operate the infrastructure for a fixed period after completion of construction. The operator’s revenues are
contingent – e.g. on the usage of the infrastructure assets.

The accounting during the construction phase is the same as that described above for arrangements resulting in financial
assets. Contract revenue is the fair value of the intangible asset received in exchange for construction services provided
in the period. During this construction phase, the operator’s asset is classified as an intangible asset.

Further revenue is recognised when money is actually received. This contrasts with the financial asset model, in which
monies received are treated as partial repayment of the financial asset. In the intangible asset model, the intangible is
reduced by amortisation rather than repayment. As a result, revenue is recognised twice in the intangible model – once
on the exchange of construction services for the intangible asset, and a second time on receipt of payments.

Intangible assets recognised in accordance with the Interpretation should be amortised over their useful lives in
accordance with the requirements of IAS 38 Intangible Assets. The IFRIC has explicitly stated that interest methods of
depreciation are not acceptable. The IFRIC also considered the statement in IAS 38 that rarely, if ever, will there be
persuasive evidence to support an amortisation method that results in a lower amount of accumulated amortisation than
under the straight-line method. Note, however, that the International Accounting Standards Board has subsequently
confirmed that this paragraph of IAS 38 should not be read as implying that amortisation methods based on reliable
estimates of usage would never be appropriate.

Financial and intangible components

Where the operator receives a financial asset and an intangible asset as consideration, it is necessary to account
separately for the component parts. At initial recognition, the assets are recognised at the fair value of consideration

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received or receivable. In practice this means that, to the extent the operator has received a contractual right to receive
cash from or at the direction of the grantor, a financial asset will be recognised. Any excess of the fair value of the
consideration paid over the fair value of the financial asset recognised will be recognised as an intangible asset.

Other issues

Borrowing costs

Borrowing costs incurred in connection with an arrangement falling within the scope of IFRIC 12 will be expensed as
incurred, unless the operator has recognised an intangible asset under the Interpretation. In this case, borrowing costs
may be capitalised in accordance with the general rules of IAS 23 Borrowing Costs.

Under the financial asset model, borrowing costs cannot be capitalised, because the financial asset will not meet the
definition of a qualifying asset under IAS 23.

Repairs and maintenance

IFRIC 12 requires that any obligation to maintain or restore the infrastructure under the terms of the arrangement be
recognised and measured in accordance with the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent
Assets.

Disclosure

IFRIC 12 does not contain any disclosure requirements. Requirements for disclosing information about service concession
arrangements are set out in SIC 29 Service Concession Arrangements: Disclosures (previously titled “Disclosure – Service
Concession Arrangements”).

Consequential amendments to SIC 29 replace the terms “Concession Operator” and “Concession Provider” with
“operator” and “grantor” respectively, to bring the terminology into line with IFRIC 12. In addition, SIC 29 will require the
operator to disclose the following after the implementation of IFRIC 12:

• how the service arrangement has been classified; and

• the amount of revenue and profits or losses recognised in the period on exchanging construction services for a financial
asset or an intangible asset.

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