How should a key management insurance policy ("KMI") be accounted for from the policy holder’s perspective?
Company A entered into a KMI with an insurance company. The policy is a universal life insurance policy which combines an investment arrangement with insurance of the life of a key man (such as the CEO, founder, etc). Company A is the beneficiary under the KMI.
The key features of the KMI are as below:
Single (one-off) on day 1
6 times of premium (pay-out will be the higher of the value of the account balance or the death benefit)
Earlier of the CEO reaching the age of 99 or his death.
- Fixed interest rate of 4% for the 1st year.
- Minimum interest rate (3%-4.8%) thereafter.
- Additional interest at the insurer's discretion. It has been assessed and concluded that this is not a discretionary participation feature in the scope of IFRS 4.
- Co A has the right to surrender the KMI partially or in full at any time at cash surrender value.
- Cash surrender value = account value - surrender charge.
- Account value= premium paid - initial charge + interest earned - monthly charges.
- Surrender charges: decrease progressively from year 1 and becomes nil onwards from year 16.
- Initial charge (Policy Premium Charge): fixed percentage (e.g. 6%) * the premium paid.
- Monthly charges:
- Admin expense charge (Policy Expense Charge) : fixed amount per month for first 15 years.
- Insurance risk premium (Insurance Charge): determined by the insurer based on the insured's age, sex and death benefit, which increases progressively.
The flowchart below summarises the questions Company A will need to consider and the resulting accounting treatment for the KMI. Further detail on each step is given below.
Question 1: Does the contract contain significant insurance risk?
The KMI comprises two components, the insurance component and deposit/investment component. The insurance component represents insurance coverage (death benefit) for the insured (key man). The deposit/investment component represents the premium and interest credited by the insurer.
IAS 39 paragraph 2(e) scopes out rights and obligations under insurance contracts. However, a contract meets the definition of an insurance contract in IFRS 4 Appendix A only if it contains significant insurance risk. If the insurance risk is not significant, then the arrangement is a financial instrument that is accounted for under IAS 39.
Insurance risk is defined in IFRS 4 Appendix A as a risk, other than financial risk, transferred from the holder of a contract to the issuer.
As per IFRS 4 Appendix B, insurance risk is significant if, and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance.
The KMI in the Illustration above is likely to contain a significant insurance risk.
Question 2: If the KMI does NOT contain significant insurance risk, how should it be accounted for by the policyholder?
If the contract does not contain significant insurance risk, IAS 39 is applied to the whole contract (that is, an investment contract with discretionary participation feature). The contract does not meet the definition of an insurance contract and so the exception in IAS 39.2 (e) does not apply.
Under IAS 39, the contract would be accounted for as comprising:
- A host contract, which is classified in accordance with IAS 39.9. An acceptable classification could be a mixture of:
- Available for sale debt component - for the contractually required non-discretionary cash flows up to maturity, (being the earlier of when the CEO reaches age 99 or his/her death**), and
- Available for sale equity component (for the discretionary interest).
** Company A will need to consider mortality rates in assessing the estimated maturity of the available for sale debt component.
- An embedded derivative, being the surrender option (which is an embedded put option held by the policy holder). The surrender option should be assessed as to whether it is closely related to the host contract. The assessment is performed by assessing whether the exercise price for the surrender option is approximately equal on each exercise date to the host’s amortised cost (IAS39.AG30(g)). In the illustration above, it is likely that the surrender option is not closely related to the host contract, and therefore is separated and accounted for separately as a derivative asset measured at fair value through profit or loss.
Alternatively, if the embedded derivative is not closely related to the host contract, Company A can choose to designate the whole contract as at fair value through profit or loss since it contains an embedded derivative that would otherwise need to be separated (IAS 39.11A).
Question 3: If the KMI DOES contain significant insurance risk, how should it be accounted for by the policyholder?
From the insurer’s perspective, when insurance risk is significant, the policy is accounted for as an insurance contract under IFRS 4. However, the policyholder’s accounting is scoped out from both IFRS 4 (see paragraph 4(f)) and IAS 39 (see paragraph 2(e)).
As a result, there is no specific accounting standard in IFRS applicable to KMI from the policyholder’s perspective. However, IFRS 4 paragraph BC73(c) notes that the hierarchy of criteria in paragraphs 10–12 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors applies.
IAS 8 paragraph 10 requires that in the absence of an IFRS that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy.
Below we present some acceptable accounting treatments, from the policyholder’s perspective, for a KMI that contains significant insurance risk.
Accounting alternative 1 – Apply other guidance in IFRS by analogy
As per IAS 8 paragraph 11, in making the judgement for defining an accounting policy, management shall refer to, and consider the applicability of, the following sources in descending order:
- the requirements in IFRSs dealing with similar and related issues; and
- the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Conceptual Framework for Financial Reporting.
Based on the above, if the insurance risk is significant, the entity may choose to unbundle the insurance component and the deposit/investment component by analogy to IFRS4.10.
If unbundling is selected:
If unbundling is selected, the accounting is as follows:
- IAS 39 is applied to the deposit/investment component. This is initially recognised at fair value. Under IAS 39 the deposit/investment component is comprised of the following:
- The host contract which is classified in accordance with IAS 39.9. In the Illustration above, an acceptable classification could be a mixture of:
- a debt component - for the contractually required non-discretionary cash flows up to maturity which in the example above is when the CEO reaches 99 years of age. This could be classified as available for sale debt or as a loans and receivables. Note that in this case the debt component ignores the possible acceleration of maturity on death, as this death benefit is the insurance component, which is unbundled and accounted for separately. and,
- an available for sale equity component (for the discretionary interest).
- An embedded derivative, being the surrender option (which is an embedded put option held by the policyholder). The surrender option should be assessed as to whether it is closely related to the host contract. The assessment is performed by assessing whether the exercise price for the surrender option is approximately equal on each exercise date to the host’s amortised cost (IAS39.AG30(g)). In the illustration above, it is likely that the surrender option is not closely related to the host contract, and therefore it would be separated and accounted for separately as a derivative asset measured at fair value through profit or loss.
Alternatively, by analogy to IFRS 4.8 and IFRS 4.IG Example 2.13, the entity may choose to include the surrender option in the insurance component (in which case it might not be separated, as described below). This is an accounting policy that should be applied consistently.
Alternatively, if the embedded derivative is not closely related to the host contract, Company A can designate the whole investment component as at fair value through profit or loss since it contains an embedded derivative that would otherwise need to be separated (IAS 39.11A).
- The insurance component is recognised as a prepayment asset at cost (the residual amount of consideration paid after deducting the fair value of the investment component) less amortisation/impairment. As noted above, Company A may make an accounting policy choice to account for the surrender option as part of the insurance component by analogy to IFRS 4.8 and IFRS 4.IG Example 2.13. If it does so, it is not required to separate an embedded derivative for the surrender option provided it recognises all its obligations under the deposit component.
If unbundling is not selected
Alternatively the entity may choose not to unbundle, either by electing to analogise to IAS 39 rather than IFRS 4, or by electing to analogise to IFRS 4 but making an accounting policy choice not to unbundle contracts that contain both an insurance component and a deposit/investment component. In this case the entity accounts for the KMI under IAS 39, and applies the guidance under Question 2 above.
Alternative 2 – Apply by analogy pronouncements of other standard-setting bodies
In accordance with IAS 8 paragraph 12, in making the judgement for defining an accounting policy where there is no specific standard that applies in IFRS, management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in IFRS.
We believe that one of the accounting frameworks an entity may elect when accounting for a KMI that contains significant insurance risk, is the guidance for KMI under US GAAP. The relevant US GAAP guidance is attached in Appendix 1. In summary:
- The investment is recognised initially at the amount of the premium paid, without separation of the insurance and investment components;
- Subsequently the investment is measured at the amount that could be realised under the insurance contract (cash surrender value) at each balance sheet date, with changes recognised in profit or loss.
Appendix 1: US GAAP References
35-1 An asset representing an investment in a life insurance contract shall be measured subsequently at the amount that could be realized under the insurance contract as of the date of the statement of financial position. It is not appropriate for the purchaser of life insurance to recognize income from death benefits on an actuarially expected basis. The death benefit shall not be realized before the actual death of the insured, and recognizing death benefits on a projected basis is not an appropriate measure of the asset.
35-2 The change in cash surrender or contract value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contract for the period.
35-3 Paragraph 325-30-30-1 states that a policyholder shall consider any additional amounts included in the contractual terms of the policy in determining the amount that could be realized under the life insurance contract. When it is probable that contractual terms would limit the amount that could be realized under the life insurance contract, these contractual limitations shall be considered when determining the realizable amounts. Those amounts that are recoverable by the policyholder at the discretion of the insurance entity shall be excluded from the amount that could be realized under the life insurance contract.
35-4 Amounts that are recoverable by the policyholder in periods beyond one year from the surrender of the policy shall be discounted in accordance with Topic 835.
35-5 A policyholder shall determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). Any amount that ultimately would be realized by the policyholder upon the assumed surrender of the final policy (or final certificate in a group policy) shall be included in the amount that could be realized under the insurance contract. See Example 1 (paragraph 325-30-55-1) for an illustration of this guidance.
35-6 A policyholder shall not discount the cash surrender value component of the amount that could be realized under the insurance contract when contractual restrictions on the ability to surrender a policy exist, as long as the holder of the policy continues to participate in the changes in the cash surrender value as it had done before the surrender request. If, however, the contractual restrictions prevent the policyholder from participating in changes to the cash surrender value component, then the amount that could be realized under the insurance contract at a future date shall be discounted in accordance with Topic 835.
35-6A Paragraph 325-30-30-1A states that an entity also shall apply the measurement guidance in paragraphs 325-30-35-5 through 35-7 at initial measurement.
35-7 If a group of individual-life policies or a group policy only allows for the surrender of all of the individual-life policies or certificates as a group, then the policyholder shall determine the amount that could be realized under the insurance contract on a group basis.