In May the IASB issued its long-awaited DP on accounting for insurance contracts. Project Director Simon Peerless summarises the proposals and their implications for other areas of financial reporting.

This represents the IASB's first comprehensive proposals for recognition and measurement issues for insurance contracts - the existing standard, IFRS 4 Insurance Contracts, was issued in 2004 with the main purpose of enabling insurers to adopt full IFRS whilst continuing their existing accounting policies for insurance contracts with little modification.

The central part of the discussion paper (DP) deals with the measurement of insurance liabilities. The DP proposes that all such liabilities should be measured on a current exit value basis. A model is proposed, comprising three 'building blocks':

• an unbiased probability-weighted estimate of the future cash flows
• adjustment for the time value of money using current market discount rates
• an explicit margin for bearing risk and providing services

Each of these building blocks would be estimated based on the amount an insurer would have to pay to transfer the contractual rights and obligations under the policy to another insurer at the balance sheet date. However, such transfers rarely if ever occur; in order to estimate these elements (and in particular the amount of risk margin) it will be necessary to consider a hypothetical transaction. In practice, in many cases the only available information will be the insurer's own pricing data. The DP emphasises that the adoption of a current exit value model does not imply that the insurer can, will or should transfer the liability to a third party.

The DP discusses whether the value of a liability should be 'calibrated' to the transaction price by adjusting the risk margin in the valuation so that the initial value is equal to the premiums agreed (taking into account the insurer's costs of entering into the transaction). If the value is not calibrated in this way, a 'day one' gain or loss can arise, reflecting the difference between the premium agreed with the policyholder and the current exit value determined by the valuation model. The IASB was split on this issue, with a small majority in favour of no calibration.

The DP discusses whether the value of a liability should be 'calibrated' to the transaction price by adjusting the risk margin in the valuation so that the initial value is equal to the premiums agreed (taking into account the insurer's costs of entering into the transaction). If the value is not calibrated in this way, a 'day one' gain or loss can arise, reflecting the difference between the premium agreed with the policyholder and the current exit value determined by the valuation model. The IASB was split on this issue, with a small majority in favour of no calibration.

The DP goes on to consider contracts - such as life assurance - where the insurer expects the majority of policyholders to continue to pay premiums over the whole term of the contract, but has no contractual rights to this; policyholders can choose to cancel the contract at any time. The profitability of a group of such contracts can often depend on the assumption that, subject to estimated lapse rates, policyholders will continue to pay premiums. The DP proposes that these future premiums can be included in the valuation of the contracts where continued payment gives the policyholder continuing insurance cover on the existing terms. However, the DP notes that conceptually these future premiums are more in the nature of an intangible asset representing part of the customer relationship.

The DP proposes that for participating contracts (such as with-profits life assurance) the liability should include those benefit payments that the insurer is contractually or constructively obliged to make, but not additional benefits that are discretionary. Surpluses in life funds in excess of the insurer's obligations to policyholders are therefore treated as equity even though shareholders are entitled to only a small proportion of these.

The DP also addresses the presentation of income and expenses arising from insurance business, including the treatment of changes in the value of liabilities.

It also proposes that in some circumstances in may be necessary to separate out components of insurance contracts that are in effect financial instruments - for example, where a life assurance policy is effectively a combination of a savings product and death benefit insurance.

As well as having major implications for insurers, the IASB's conclusions on these issues will have a bearing on their analysis of related issues in non-insurance financial reporting. Key areas include:

• the adoption of a current exit value model for liabilities for which no market exists;
• revenue recognition based on changes in the value of liabilities rather than on the extent to which services have been delivered to customers;
• recognition of future income that is not contractually enforceable;
• separation or 'unbundling' of financial instrument components of contracts;
• recognition and measurement of non-financial liabilities;
• the distinction between liabilities and equity; and
• the relationship to the measurement of pensions liabilities.

The ASB has issued a briefing paper on these issues (available from www.frc.org.uk/asb) and encourages all those involved in financial reporting - not just insurance - to consider these issues and respond to the DP's proposals. The IASB's comment deadline is 16 November 2007.