Proposed IASB Discussion Paper Accounting Standard for Insurance—Back to the Future

In May 2007, the International Accounting Standards Board (IASB) issued a discussion paper entitled “Preliminary Views on Insurance Contracts.” The discussion paper proposes a new accounting model applicable to all insurance contracts including life and non-life. The model for insurance reserve liabilities is “current exit value” (CEV), where CEV is defined as the amount that an insurer would expect to pay to transfer its remaining contractual rights and obligations to another entity. This amount is determined by three building blocks: (1) a probability-weighted best estimate of future cash flows; (2) which is discounted for the time value of money; and (3) to which is added an explicit margin to compensate a potential purchaser for assuming the risk. Remarkably, there is history for a similar market-based approach to reserving in U.S. regulation of property/casualty companies and in the tax law dealing with unearned premium reserves.

The concept of unearned premiums found its origin in the fire insurance business in New York. The comptroller of New York inserted in the 1858 Fire Annual Statement blank a liability item for the “Amount required to safely reinsure all outstanding risks, estimated by the President and Secretary.” This liability was later identified as an “unearned premium reserve” in the New York Insurance Law. The primary purpose of the unearned premium reserve was to assure the continuance of coverage in the event the company became insolvent. Insolvency was a particular risk for fire insurers in the mid-1800s due to the predominance of wooden construction and spotty fire protection. As exposure to catastrophic losses from fire lessened and the availability of reinsurance increased, the concept of unearned premium reserves evolved from its original reinsurance-value concept to either the appropriate amount that would be returned to policyholders if the insurer canceled all its policies or the unearned portion of the premium on the unexpired risks under existing policies. Life insurance reserves never followed a similar evolution. At the same time the New York comptroller adopted the original definition of unearned premium reserves, Elizur Wright in Massachusetts was developing a formulaic net premium valuation method which ultimately became the model for the Standard Valuation Law adopted 90 years later.