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Draft for discussion at ICAEW IISC meeting, 20th June 2005 - page 36 / 51





36 / 51

  • The bulk of profits would be upfront (discussed further below). Many analysts think this is acceptable but the view of the accountancy profession is crucial.

  • Mismatches would create volatility of results—though many analysts think this is ‘liveable with’. Perhaps use the ‘longer term rate of investment return’ example in the SORP for how to get some smoothed measure of assets on which to base calculation of ‘operating profit’.

  • Especially in early years the ‘liability’ could be negative: i.e. an asset. This is valid on a portfolio basis.

Are ‘up-front profits’ acceptable? Not if IAS18 ‘stage of completion of contract’ means ‘in proportion to elapsed duration’. But the IASC’s Steering Committee on Financial Instruments March 1997 Discussion Paper Accounting for Financial Assets and Financial Liabilities says ‘all gains and losses arising from changes in the FV of financial assets and financial liabilities are income, and should be recognised as income immediately they arise’. However, can one do more than carry forward DAC (i.e. effectively only recognising that much of future margins in advance)? So current accounting principles are unclear: ‘the actuaries look to the accountants for clarification as it is eventually the accountants who must decide.’

The paper discusses the pros and cons of upfront profit recognition. It rejects alternatives to FV for asset values (except that ‘amortised cost’ of bonds may be appropriate if liabilities are not actively valued). For liabilities, it reviews the various current GAAPs worldwide. If one uses an ‘active basis’ one has to decide with regard to changes in actuarial assumptions whether to use ‘fresh start’ (i.e. with whole difference in current income); ‘prospective’ over period of new assumptions (e.g. for gross premium valuation by adjusting profit margin to get same overall measure); or ‘lock-in’—all subject to overriding recognition of any overall loss on the new assumptions.

The paper reviews the IASC Framework para. 37 and IAS37 and argues that taken together the principles of neutrality, prudence and provision recognition seem to imply something close to a ‘best estimate’ approach (i.e. without margins for adverse deviations). Currently Australian GAAP adds a profit margin, Canadian GAAP a margin for adverse deviations, and South African GAAP both, to the basic ‘best estimate’. Could all these additions be regarded as ‘profit margins’?

Should all changes in FV go through the income statement? The alternative is smoothing (as in the SORP re. investment return). But while possible for bonds, ‘the smoothing approaches to equities that have been tried (average value, recognition of realised appreciation only etc.) do not seem to have proved satisfactory.’ So it is a matter for debate whether there is a satisfactory method for smoothing assets. For liabilities, a passive method, such as net premium valuation plus a DAC asset, would achieve a measure of smoothing.

Deciding on whether to split the FFA (remembering that the policyholder share of the estate may include future policyholders) is important for ‘international’ GAAP.

A number of subsidiary questions are reviewed including ‘what should the Ideal Profit Signature67 look like?’ If the contract is regarded as part service and part financial instrument (rather than wholly as a financial instrument) then it is reasonable

67 Unlike the ‘Profit Profile’, the Profit Signature assumes all profit is distributed as it arises so that the investment return is only on current year cash flows and on the opening policy provision. Using the rate assumed for investment return as the discount rate, discounted profit signatures all have same present value. In a steady state all GAAP give the same annual profit.


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