22-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Chapter 22 Accounting for general insurance contracts

22-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Learning objectives Understand the asset measurement rules that are to be applied to the assets that back general insurance liabilities Understand how the liabilities pertaining to general insurance contracts are to be measured Know about the discount rate that should be used to discount liabilities to their present value

22-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Learning objectives (cont.) Understand the revenue and expense recognition principles that should be adopted in relation to general insurance contracts Be aware of the disclosure requirements of AASB 1023

22-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Status of newly converged accounting standards For Phase I of the IASB’s ‘Insurance Project’, the AASB has significantly altered and reissued –AASB 1023 ‘General Insurance Contracts’ –AASB 1038 ‘Life Insurance Contracts’ The AASB also released –AASB 4 ‘Insurance Contracts’

22-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Introduction to general insurance contracts Currently we have three accounting standards dealing with insurance 1.AASB 4 2.AASB AASB 1038 The IASB is currently working on Phase II of the ‘Insurance Project’ –it is expected that a revised standard will replace these three standards This chapter focuses on AASB 1023

22-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The role of the HIH Royal Commission It appears that the re-release of AASB 1023 was affected by the Royal Commission Collapse of HIH Insurance Ltd in 2001 was one of the worst corporate collapses in Australia Justice Neville Owen commented that –the interpretation of certain key accounting standards was not straightforward –wider participation in standard setting would be beneficial –the ‘true and fair’ concept is not given sufficient consideration

22-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The role of the HIH Royal Commission (cont.) Justice Neville Owen commented that (cont.) –an important factor contributing to HIH’s failure was inaccurate reporting of financial information –inadequate reporting was caused partly by misinterpretation of and deficiencies in standards Justice Owen’s recommendations for AASB 1023 were the following –the definition of insurance should include a requirement for material transfer of insurance risk –insurance liabilities should be valued at level of sufficiency of at least 75 per cent

22-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan The role of the HIH Royal Commission (cont.) Justice Owen’s recommendations for AASB 1023 (cont.) –entities should disclose in their financial statements: valuation of insurance liabilities, 75 per cent level of sufficiency and margin adopted –premium revenue and insurance liabilities should be recognised on commencement of contract –in estimating the present value of liabilities, a risk-free rate similar to that of prudential standards should be used –companies should disclose a 10-year claims development table

22-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Introduction to the requirements of AASB 1023 AASB 1023 applies to –general insurance contracts –certain assets backing general insurance liabilities –financial liabilities and financial assets under non-insurance contracts –certain assets backing financial liabilities under non-insurance contracts General insurance contract –insurance contract that is not a life insurance contract

22-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Introduction to the requirements of AASB 1023 (cont.) Life insurance contract –insurance contract or financial instrument with a discretionary participation feature regulated under the Life Insurance Act 1995 General insurance –typically for losses associated with theft, storms, vehicle accidents, fire and flood –plays a valuable role in economic activity

22-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Recognition of insurance premium revenue Revenue to be brought to account from the ‘attachment date’ provided it can be measured reliably (AASB 1023) –attachment date is the date from which the insurer accepts the risk Revenue recognised should be tied to the pattern of the incidence of risk Most insurers bring revenue to account on a time basis, with an equal amount being attributed to each period –considered appropriate if risks are uniform throughout the life of the policy

22-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Recognition of insurance premium revenue (cont.) Steps in measuring premium revenue (AASB 1023) a)estimate total amount of expected premium revenue; b)estimate total expected claims expense and timing of claims; c)estimate pattern of incidence of risk from b); and d)recognise premium revenue in a) when it will be earned

22-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Revenue associated with unclosed business Unclosed business –business written close to the balance date in respect of which the date of attachment of risk precedes the balance date –insurer agrees to accept the risk before the customer has completed policy contract (i.e. cover note) –estimate of earned portion of premium relating to unclosed business is necessary for inclusion in premium revenue

22-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Reinsurance Common for insurers to reinsure some or all of their insurance portfolio with another insurer Direct insurer –the entity that originally wrote an insurance contract –must show all premiums received, including those redirected –premiums transferred to reinsurer are an expense of the direct insurer

22-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Reinsurance (cont.) Reinsurer (AASB 1023) –party that has an obligation under a reinsurance contract to compensate an insured party if an insured event occurs –reinsurance premiums received are treated in the same way as premiums accepted by direct insurer, i.e. as revenue

22-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Reimbursement of government charges Part of premium relates to government charges (e.g. stamp duty) imposed on the insured party –not treated as revenue by insurer but as revenue held on behalf of the government (i.e. a liability) Charges levied on insurer (e.g. licence fees and workers’ compensation insurance) incorporated in insurance premium –treated as part of premium revenue

22-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Insurance claims Claims settled and paid during the year are treated as expenses of the period Expenses and liabilities should include outstanding claims at period end Outstanding claims liability measured as (AASB 1023) –central estimate of present value of expected future payments for claims and additional risk margin –central estimate is mean of distribution

22-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Insurance claims (cont.) Risk margin (AASB 1023) –relates to inherent uncertainty in central estimate –is determined on a basis reflecting insurer’s business Expected future payments include (AASB 1023) –unpaid reported claims; –claims incurred but not reported; –claims incurred but not enough reported; and –costs of settling incurred claims

22-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Requirement to discount obligations Outstanding claims liability are to be discounted to present value using (AASB 1023) –time value of money using risk-free discount rates based on current observable, objective rates that relate to the nature, structure and term of future obligation Government bond rate might be appropriate Increase in present value of claim from one period to the next is included in claims expense (AASB 1023)

22-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Requirement to discount obligations (cont.) Unearned premium liability (AASB 1023) –premiums not recognised in income statement, i.e. received but not earned –to meet costs of future claims arising under current general insurance contracts and deferred acquisition costs –acquisition costs deferred and recognised as assets where reliably measured and probable

22-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Liability adequacy test Assessment of whether carrying amounts of insurance liabilities need to be increased based on a review of future cash flows (AASB 1023) Present value of future claims to be compared with unearned premiums If present value exceeds unearned premium liability (AASB 1023) –liability is deficient; and –further liability and expense is to be recognised

22-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Assets Different measurement approaches required for financial assets, investment properties and property, plant and equipment (AASB 1023) Financial assets (defined in AASB 139) –to be measured at fair value (AASB 1023) with any changes to be included in the income statement

22-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Assets (cont.) Investment properties (AASB 140 and AASB 1023) –property held to earn rentals or for capital appreciation to be measured using fair value model under AASB 140 –any gain or loss recognised in profit or loss Property, plant and equipment (AASB 1023) –to be measured using revaluation model under AASB 116 –increases in value to a revaluation reserve unless a reversal

22-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Disclosure requirements Income statement (AASB 1023) –total deficiency –any write-downs of deferred acquisition costs –any write-downs of intangible assets –underwriting result for the period –net claims incurred –gross claims incurred (undiscounted) and reinsurance and other recoveries (undiscounted)

22-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Disclosure requirements (cont.) Balance sheet (AASB 1023) –for outstanding claims liability, central estimate and risk margin –percentage risk margin adopted –probability of adequacy –process used to determine risk margin

22-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Consistency with other standards AASB 1023 requires certain measurement approaches for ‘assets backing general insurance liabilities’ For assets not ‘backing general insurance liabilities’, alternative approaches could be used Would different valuation bases confuse account users?

22-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Opposition to AASB 1023 Major opposition to original AASB 1023 –requirement to include unrecognised gains and losses on investments in the profit and loss –claimed to introduce a degree of volatility to the accounts Also argued that results driven by marked-to- market investments would distort general insurers’ performance Some volatility will remain under current version of AASB 1023

22-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig Deegan Slides prepared by Craig Deegan Summary The chapter addresses accounting issues relating to general insurance contracts Main issues are –how and when revenue should be recognised –how and when insurance claims should be recognised –how assets should be valued Revenues to be recognised on the basis of pattern of incidence of risk Insurance claims settled and paid to be treated as expenses Unpaid insurance claims recognised as liabilities to be discounted to present values