• Which are the most important IFRSs for the accounts of a captive ?
• What is the Definition of the Insurance Contract ?
• Should we include the captive in the scope of the consolidation ?
• What happens to the Equalisation and Catastrophe Provisions?
• What is the Loss Recognition Test ?
• How do we apply the Fair Value Methodology?
• What should we do in the transition period ?

Which are the most important IFRSs for the accounts of a captive ?

IAS 12 : Income Taxes
IAS 19 : Employee Benefits
IAS 27 : Consolidated Financial Statements
IAS 32 : Financial Instruments : Disclosure and Presentation
IAS 37 : Provisions, Contingent Liabilities and Contingent Assets
IAS 38 : Intangible Assets
IAS 40 : Investment Property

What is the Definition of the Insurance Contract ?

The definition provided by the Board is the following :

"A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or other beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder or other beneficiary."

This definition was still debated in the December meetings of the IASB and as there are issues on the understanding of "significant insurance risk" and the distinction between Insurance Risk and Financial Risk becomes capital as different IFRS will apply.
There is currently no guidance on the minimum level of insurance risk to be included in a contract so that it can be defined as an Insurance Contract. It is currently usually understood by commentators that each company will have to provide its own definition in the disclosures.

In addition, captive owners have to note that, to meet this definition, an insurance contract needs to concern two parties. As a consequence, under consolidated IFRS, the Group will have to verify that the parties involved in the insurance contract are two distinct parties even at consolidated level.

Should we include the captive in the scope of the consolidation ?

Consolidation is defined in IAS 27.

IAS 27-11 requires a parent company to include all subsidiaries, foreign and domestic. The only exception is a subsidiary only temporary controlled.

As a consequence, captives have to be included in the consolidation.

However, the IFRS on Insurance Contract will apply to all insurance contracts issued, and reinsurance contracts issued or held by the Group, and therefore by the captive. As the definition of an insurance contract requires two separate parties, this will have to be checked before applying this standard on Insurance Contract or the IAS 39 on Financial Instruments.

What happens to the Equalisation and Catastrophe Provisions ?

IFRS Board states

"An insurer shall not recognise as a liability any catastrophe provisions or equalisation provisions relating to possible future claims under future insurance contracts."

The Board has decided that these reserves will not be allowed under IFRSs. Whereas a large number of comment letters insisted on the fact that this was part of the activity of an insurance company, the Board confirmed through IFRS 4 on 31.03.04 that it did not intend in Phase I, nor in phase II, to review this position.
These reserves will then be included in the Equity.

However, if the discussion on the recognition of these reserves is closed, there is still a lot of debate on the definition of the Fair Value. For many users of IFRSs, the valuation of the Fair Value could include part of this liability.

In addition, it is important for captive owners to note that the amount of reserves accumulated in the captive is usually very minor as compared to the amount of assets of the Group that will have to be valued under IFRS methods, which will imply a lot of volatility on the asset side of the Balance Sheet.

Moreover, IFRS accounts will not substitute statutory accounts. For instance, the introduction of US GAAP for US listed companies generated a separate set of accounts, as well as EU listed companies will be required from 2005 to produce a separate set of IFRS accounts.

Finally, these reserves are recognised in several EU countries, accepted by the EU directives, and there has been so far no sign from these countries to change their regulation.

What is the Loss Recognition Test ?

ED 5 requires, from Phase I therefore in 2005, that insurance companies perform a test as follows :

"An insurer shall carry out a loss recognition test at each reporting date, using current estimates of future cash flows under its insurance contracts. If those estimates show that the carrying amount of its insurance liabilities (..) is insufficient in the light of the estimated future cash flows, the insurer shall recognise the entire deficiency in profit or loss."

As a consequence, captive reinsurance companies will be required to annually review and present the result of the valuation of their future cash flows. This will need to be done by underwriting year and accounting year, for each line of business.

There will be a crucial need of a larger volume of information being kept and analysed, and captive owners will have to make sure they dispose of the relevant level of information.

Information Systems may need to be adapted to that requirement as well. Finally, an actuarial assistance to the captive owner will be a valuable asset for the implementation of such a test.

How do we apply the Fair Value Methodology ?

The Fair Value under IAS 39 is defined as :

"The amount for which an obligation or a liability settled between knowledgeable willing parties in an arm's length transaction."

however, for insurance liabilities, there is no market sufficiently liquid and the principle of the Fair Value will therefore rely on the prospective valuation of future cash flows from the current book of contracts (Closed Book Approach) with a margin for risk and uncertainty.

The assumptions of this valuation should be market ones but, as a consequence of the lack of liquidity of the market, they might be entity specific as well. These principles need to be detailed in Phase II, as there is so far very limited guidance on the methodology to be applied in practice for the Fair Value. For instance, the margin for risk and uncertainty remains very obscure and it is therefore feared that the result of such a change might be against the objective of transparency.

The Board recently admitted that the application of the Fair Value is at this stage still complicated and decided during its November meeting to cancel the requirement to disclose the Fair Value of the insurance assets and insurance liabilities as from 31 December 2006. The discussion of the disclosures required is scheduled for the next IASB meetings.

What should we do in the transition period ?

IFRS 4 essentially said that for Phase I firms should account their insurance liabilities as they do now. But the delay in Phase II has implications, especially on the question of whether anything can be done about the mismatch problem.

For more than three years, most insurers assets will be marked to market under IAS 39 where liabilities will be treated on a different basis. Liabilities will then be recorded in the variety of approaches that characterise current insurance accounting practices.

Finally, the only change confirmed is that the Equalisation Reserve will not be accounted for under IFRSs, but Equalisation Reserve will remain unchanged under local accounting standards and tax implications will therefore also not change.