Chapter 4

Insurance Contracts
An insurance contract deals with uncertainty, such as whether an event will occur, exactly
when it will occur, or the amount of a payment due when a triggering event occurs. The
contract may even deal with an event that has already occurred, but for which the related
financial effect remains unclear. The key element of the contract is that the contract issuer
accepts significant insurance risk from the insured party. Examples of insurance contracts are
noted in the following table.

Types of Insurance Contracts

Conversely, a contract that does not expose an insurer to any significant risk, or which
shifts risk back to the policyholder, is not considered an insurance contract. Self-
insurance is also not considered an insurance contract, since there is no agreement
with a third party. An insurer may sell a variety of insurance contracts to its
policyholders. This chapter describes the accounting and disclosure requirements of
insurers in regard to these insurance contracts, with a particular emphasis on the
relevance and reliability of the information presented in an insurer’s financial
statements.
4.1. Insurance Contract Aggregation

An insurer should identify clusters of insurance contracts that have similar risks, and which
are managed as a group; these clusters are known as portfolios of insurance contracts.
Insurance contracts within the same product line will probably be included in the same
portfolio, since they typically have similar risks and are managed as a group. At a
minimum, the insurer should divide each portfolio of contracts into the following groups:

• Those contracts that are onerous as of the point of initial recognition;

• Those contracts that are have no significant possibility of becoming

onerous as of the point of initial recognition; and

• All remaining contracts.

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It is allowable to further subdivide these groups, such as by differing levels of
profitability, or by differing probabilities that the contracts will become onerous at a later
date. However, the firm should not include contracts in the same group that have been
issued more than one year apart. Once contract groups have been established, their
composition should not be revised thereafter. If the company applies the premium
allocation approach to its contracts (as discussed later in the Subsequent Measurement of
Insurance Contracts section), it may assume that none of the contracts will be classified
as onerous as of the point of initial recognition, barring the presence of facts and
circumstances indicating otherwise. If the company does not apply the premium
allocation approach, the firm should evaluate whether contracts not considered onerous
at their initial recognition have no significant possibility of becoming so, based on the
following:

• The likelihood of changes in assumptions that would result in the reclassification of

contracts as being onerous.
• The use of information provided by the firm’s internal reporting system.
The measurement of contracts, as discussed in the following sections, is to be applied to
each of the contract portfolios described in this section.
4.2. Initial Recognition of Insurance Contracts
Once a group of insurance contracts has been identified, the insurer should recognize the
group as of the earliest of the following:
• The beginning of the coverage period;
• The first payment due date from a policyholder; and
• If the group is comprised of onerous contracts, the point at which the group becomes
onerous.
If there is no payment due date stated in a contract, then the first payment is considered
to be due as soon as it has been received. The insurer must recognize an asset or liability
for the insurance acquisition cash flows relating to any group of issued contracts that the
firm pays or receives prior to recognition of the group, unless it elects to recognize them
at once as income or expenses. This asset or liability is subsequently derecognized when
the group of contracts is recognized.

4.3. Initial Measurement of Insurance Contracts

When a group of insurance contracts is initially recognized, the insurer should measure it as the
total of:
 Fulfillment cash flows, which are comprised of:
 Estimated future cash flows

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  An adjustment for the time value of money as well as the financial risks associated with those
cash flows
 A risk adjustment for any non-financial risk
 The contractual service margin
Fulfillment cash flows include all of the following:
• Premium payments
• Payments made to the policyholder that are fixed
• Payments made to the policyholder that vary, depending on the returns generated by
underlying assets
• Allocated cash flows attributable to the portfolio with which a contract is associated
• Claims handling costs
• Costs incurred to provide benefits paid in kind
• Policy administration costs
• Taxes, such as value-added taxes
• Payments made as a fiduciary to meet the tax obligations of the policyholder
• Cash inflows from asset recoveries
• Allocated overhead costs
• Other costs that can be specifically charged to the policyholder
Several elements of these measurement items are described further in the following sub-
sections.
4.4. Estimated Future Cash Flows
Estimated Future Cash Flows: The estimated future cash flows included in the
measurement of a group of insurance contracts are comprised of all future cash flows
related to each contract in the group. These cash flows are derived using the
probability-weighted mean of the full range of possible outcomes, reflecting conditions
existing at the measurement date. One should estimate the probabilities and amounts of
future payments related to existing contracts based on claims already made by
policyholders, as well as any other information about the characteristics of the
insurance contracts, and any relevant historical data about the insurer’s prior
experience. The range of estimates should address the probabilities that renewal
options, surrender options, conversion options and so forth are exercised. The cash
flows arise from the substantive rights and obligations of the parties to each contract
that exist during the reporting period. Under these rights, the policyholder is required
to pay premiums to the insurer, while the insurer has an obligation to provide payouts
to the policyholder under certain circumstances.

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4.5. Discount Rates Used
An insurer must adjust its contract-related cash flows for the time value of money. The
discount rate used to derive this present value should be based on the characteristics of
the cash flows and the liquidity characteristics of the underlying contracts, and be
consistent with the observable market prices of any financial instruments having cash
flows with timing and liquidity similar to those of the insurance contracts.
4.6. Risk Adjustment for Non-Financial Risk
When the insurer bears some uncertainty for cash flows relating to non- financial risk, it
should adjust the estimated present value of future cash flows for the compensation being
paid to the insurer for this risk. This risk adjustment should have the following
characteristics:
• A higher risk adjustment is needed for risks with low frequency and high severity than
for risks with high frequency and low severity.
• A higher risk adjustment is needed for contracts with a longer duration than contracts
with a shorter duration.
• A higher risk adjustment is needed when there is a wider probability distribution than
for a risk with a narrower distribution.
• A higher risk adjustment is needed when less is known about the current estimate.
4.7. Contractual Service Margin
The unearned profit that an insurer will eventually earn as it provides services is called
the contractual service margin. The insurer should measure this service margin when it
initially recognizes a group of insurance contracts.
EXAMPLE
Angus Insurance provides various types of insurance to farmers, including crop
insurance, dairy insurance, equine insurance, and poultry insurance. Angus issues 100
crop insurance contracts that have a coverage period of three years. None of these
contracts are expected to lapse prior to the end of the coverage period. Angus expects to
receive premiums of £1,800,000 right after the initial recognition of the group of
contracts, which results in a present value of these premiums of £1,800,000. An initial
review of the cash flows associated with these contracts suggests that there will be
annual cash outflows of £400,000. Using a discount rate of 6%, the present value of
these cash outflows is £1,069,200. Angus estimates that the risk adjustment for non-
financial risk is £150,000. This information results in the following measurement:

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 4.8. Subsequent Measurement of Insurance Contracts
At the end of each reporting period, an insurer should measure the carrying amount of
each group of insurance contracts. This carrying amount is comprised of:
• The remaining coverage liability, which is comprised of the fulfillment cash flows
related to future service, plus the contractual service margin.
• The liability for incurred claims, which is comprised of the fulfillment cash flows
related to past service. In addition, the insurer can recognize income and expenses for
the following changes in the carrying amount of the liability for a contract’s remaining
coverage:
• Insurance revenue, which is derived from any reduction in the liability for remaining
coverage (which occurs when services are provided).
• Insurance service expenses, for any losses incurred on groups of onerous contracts,
as well as for the reversal of any of these losses.
• Insurance finance income or expenses, which is derived from the time value of
money and effects of any financial risk. Further, the insurer can recognize income and
expenses for the following changes in the carrying amount of the liability for a
contract’sincurred claims:
4.9. Modification of Insurance Contracts:
• Insurance service expenses, which are derived from any increase in the liability due to claims
and expenses incurred in the reporting period.

• Insurance service expenses, which are derived from any subsequent changes in fulfillment
cash flows associated with incurred claims and expenses.

• Insurance finance income or expenses, which is derived from the time value of money and
the effects of any financial risk.

Finally, the insurer must measure the contractual service margin as of the end of the reporting
period. This amount represents the profit in a contract group that had not previously been
recognized because it related to future services yet to be provided. When a contract does not have

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a direct participation feature, the contractual service margin’s carrying amount at the end of a
reporting period equals the amount at the beginning of the period, adjusted for the impact of new
contracts on the group, interest accreted on the carrying amount of the contractual service margin
in the period, changes in fulfillment cash flows, the effect of currency exchange differences on
the service margin, and the amount recognized as insurance revenue in the period. A portion of
the contractual service margin is recognized in each period for a group of insurance contracts.
The amount recognized should reflect the services provided in the period. The amount to be
recognized is calculated in the following manner:

1. Identify the coverage units (quantity of coverage) in a group of contracts.

2. Allocate the contractual service margin to each coverage unit that was provided in the current
period and expected to be provided at a later date.

3. Recognize the profit or loss associated with the amount allocated to those coverage units
provided in the current period. When an insurance contract has been classified as onerous, the
insurer should recognize a loss in the amount of the net outflow from the contract, so that the
resulting carrying amount of the liability equals its fulfillment cash flows, and the contractual
service margin is zero. Once a loss has been recognized on a group of onerous contracts, the
insurer should allocate any subsequent changes in fulfillment cash flows of the liability for
remaining coverage systematically, between the liability for remaining coverage and the loss
component of the liability for remaining coverage. If there is a subsequent decrease in fulfillment
cash flows that is caused by changes in the estimates of future cash flows, allocate it to the loss
component until its balance is reduced to zero. An insurer can use the simpler premium
allocation approach to measure insurance contracts, but only if there is an expectation that doing
so will yield an outcome that does not differ materially from the preceding approach, and the
contract coverage period is one year or less. To use the premium allocation approach:

• At the initial point of recognition, the carrying amount of the liability is any premiums
received at that point, minus any insurance acquisition cash flows (unless they are recognized as
an expense), plus or minus any amount caused by the derecognition of the asset or liability
recognized for insurance acquisition cash flows.

• For each subsequent reporting period, the carrying amount of the liability is the liability at
the beginning of the period, plus all premiums received in the period, minus any insurance
acquisition

cash flows (unless they are recognized as expense), plus the amortization of insurance
acquisition cash flows recognized in the period (unless they were recognized as expense), plus
any financing component adjustments, minus the recognized insurance revenue for coverage
provided in the period, minus any investment component paid for incurred claims. There is no
requirement to adjust future cash flows for the time value of money and any effects of financial
risk if they are expected to be received within one year of the date when the claims are incurred.

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EXAMPLE

Assume the same facts presented earlier for the example involving Angus Insurance. All of the
expectations outlined at the initial recognition of the contracts turn out to be exactly correct in
Year 1. However, the outcome is different in Year 2, when a reduction in incurred expenses
increases the expected profitability of the group of contracts. The results appear in the following
table.

4.10. Derecognition of Insurance Contracts

An insurer can derecognize an insurance contract when it has been extinguished or modified; in
the latter case, see the preceding discussion of modifications of insurance contracts. When a
contract is extinguished, the insurer is no longer at risk, and so is not required to transfer any
resources to satisfy the terms of the contract. When a contract within a group of contracts is
derecognized, the insurer should take these steps:

• Adjust the fulfillment cash flows of the group to remove the present value of future cash flows
and any risk adjustment for non-financial risk that has been derecognized from the group.

• Alter the contractual service margin to adjust for the change in fulfillment cash flows.

• Revise the number of coverage units to reflect the number of these units derecognized from
the group.

Accounting Policy Changes

Quite a large number of accounting policies may relate to the accounting for insurance, and each
of them can have an impact on the amounts recognized or the classification of balance sheet
items. The following table contains a sampling of the transactions to which accounting policies
could be applied.

Transactions to Which Accounting Policies Could be Applied

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4.11. Presentation of Insurance Contract Information

An insurer should separately present in the balance sheet the following carrying amounts for
groups of contracts that are:

• Insurance contracts that are assets

• Insurance contracts that are liabilities

• Reinsurance contracts that are assets

• Reinsurance contracts that are liabilities

In the statement of financial performance, the insurer should separately present an insurance
service result that includes insurance revenue and insurance service expenses. The insurer should
also separately present any insurance finance income or expenses; these items are related to
changes in the effect of the time value of money and financial risk. Any income or expenses
related to reinsurance contracts should be presented separately.

4.12. Disclosures

The financial disclosures made by an insurer should allow users to assess the effects of insurance
contracts on the firm’s finances. With this goal in mind, the following disclosures are required:

• Premium allocation approach. If the firm uses the premium allocation approach, it should
disclose how it qualified for the use of this approach, whether it makes an adjustment for the
time value of money and the effect of financial risk, and the method chosen to recognize
insurance acquisition cash flows. Several of the following disclosures have reduced requirements
if the insurer has used the premium allocation approach.

• Reconciliations. Present a reconciliation that demonstrates how the net carrying amount of
contracts changed during the period due to cash flows, as well as income and expenses
recognized in the financials. There should be separate reconciliations for insurance contracts
issued and reinsurance contracts held, as well as separate reconciliations for:

o Net liabilities or assets for the remaining coverage component Any loss component

o Any liabilities for incurred claims

o Estimates of the present value of future cash flows

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o Risk adjustments for non-financial risk

o Contractual service margin

• Insurance revenue. Disclose an analysis of insurance revenue, including any amounts

relating to changes in the liability for remaining coverage, as well as the allocation of that
portion of insurance premiums relating to the recovery of insurance acquisition cash flows.

• Balance sheet effect. State the effect on the balance sheet for insurance contracts issued and
reinsurance contracts held that have just been recognized in the period, showing their impact at
the point of initial recognition on the estimated present value of future cash outflows, the
estimated present value of future cash inflows, the risk adjustment for non-financial risk, and the
contractual service margin. When making this disclosure, separately state the information for
acquired contracts and onerous contracts.

• Recognition of contractual service margin. Explain when the firm expects to recognize the
contractual service margin that remains at the end of the reporting period, stating this information
separately for contracts issued and reinsurance contracts held.

• Insurance finance income or expense. Explain the total amount of insurance finance or
expense, noting the relationship between these items and the investment return on the firm’s
assets.

• Direct participation features. When contracts contain direct participation features, describe
the structure of the underlying items and their fair value, along with several additional
disclosures for less likely situations.

• Judgments. Note the significant judgments made in applying this accounting standard. In
particular, disclose the inputs, assumptions, and estimation techniques used. Also, if insurance
finance or income was reported separately, explain the methods used to determine this amount
that was recognized in profit or loss.

• Confidence level. State the confidence level used to arrive at the risk adjustment for non-
financial risk.

Yield curve. Disclose the yield curve used to calculate discounted cash flows that do not vary
based on the returns generated by underlying items.

• Nature and extent of risks. Disclose a sufficient amount of information to enable users of the
firm’s financial statements to evaluate the nature, timing, amount, and uncertainty of future cash
flows associated with insurance contracts. For each type of risk, state the risk exposure and how
it arises, the firm’s objectives and processes for managing the risk, how the risks are measured,
and

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how these items have changed from the preceding period. Also summarize quantitative
information about the firm’s exposure to risk as of the end of the reporting period.

• Regulatory frameworks. Discuss the effect of the regulatory frameworks within which the
firm operates, such as its minimum

required capital.

• Risk concentrations. Disclose all significant concentrations of risk related to insurance

contracts, noting how these concentrations are determined and how each risk concentration is
defined (in terms of a shared characteristic).

• Sensitivity analysis. Note the firm’s sensitivities to changes in risk exposures related to its
insurance contracts, providing an analysis of how profits and equity would be impacted by those
changes in risk exposures that are reasonably possible. Also state the methods and assumptions
used to prepare this analysis, and disclose any changes in these methods and assumptions from
the previous period.

• Actual claims. Disclose how actual policyholder claims compared to prior estimates of the
undiscounted amount of the claims. Reconcile this disclosure to the aggregate carrying amount
of the groups of insurance contracts.

• Credit risk. Disclose the amount of credit risk that best represents the maximum exposure to
credit risk. Also provide information about the credit quality of any reinsurance contracts held
that are assets.

• Liquidity risk. Describe how the firm manages liquidity risk, providing a maturity analysis
for groups of insurance contracts, showing net cash flows for each of the next five years and in
aggregate beyond that period.

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