Stefan Engeländer, Aktuar DAV, KPMG Cologne
Consideration of Acquisition Cost in Measurement of Insurance Contracts
under IFRS Phase II
Summary
The acquisition process of insurers is a highly complex activity, including both, customer
search and risk assessment. The resulting significant cost, specifically in case of contracts of
decades of duration, are an extraordinary burden for the current period and cause
counterintuitive results since the losses occur in direct proportion to the success of acquisition
activities if the related revenue, specifically from single premiums directly paid, is fully
deferred over the coverage duration. Consequently, it was one of the main intentions of
traditional insurance accounting to demonstrate that the acquisition cost are covered by the
business acquired. Under the principles of the IASB’s Revenue Recognition project, it is
doubted whether there is an accounting justification for initial recognition of revenue in case
of insurance contracts, while in other industries revenue is not recognized initially.
This paper argues that the special circumstances of insurance justify an initial recognition of
customer considerations as far as related to the acquisition procedure in accurately applying
the principles of the Revenue Recognition Project.
The acquisition procedure is a typically unwritten service contract with a success fee aiming
for a promise of insurance coverage. The success fee is charged as part of the premiums of the
subsequently agreed insurance contract if the acquisition procedure is successful. The initial
performance obligation from the service contract is satisfied and consequently related revenue
recognized by achieving the insurance promise for a specified duration. The insurance
promise is an asset itself which is transferred at outset of the insurance contract. Providing the
permanent insurance promise at outset enables the policyholder e.g. to take immediately a
loan on the insured good.
Technically the acquisition process results in a permission to insert the individual risk into the
insurance pool which means an advantage for the policyholder. The acquisition procedure is
an integral part of the insurance production process, which ultimately means to pool risks. It is
as well relevant, that the acquisition process is not a search for an acquirer of a pre-defined
good but a process were a product is developed derived from the individuality of the
customer. Hence, the acquisition process is in its entirety a part of the service already to the
specific customer. It is nearly unique for insurance contracts that the contracts refer to the
peculiarities of the individual counterparty and that nevertheless significant parts of the
production process are provided before issuance based on a success fee, due when the risk is
accepted.
The principles of the Revenue Recognition Project require that some of the premiums are
recognized as revenue initially to reflect of the satisfied performance obligation represented
by the acquisition process under the contract before, which is merged with the subsequent
insurance contract. This outcome covers in the first step single premiums and legally
enforceable regular premiums. Recognition of uncertain since non-enforceable future regular
premiums is a further question to be solved in a separate study.
Introduction
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IASB and FASB are developing an IFRS Insurance Contracts. They decided tentatively to
apply a measurement approach which is a combination of their findings in the Liabilities
Project and the Revenue Recognition Project. Specifically, they decided tentatively that the
measurement should not result in initial gains, specifically not in the initial recognition of
revenue to be consistent with the general principle of the Revenue Recognition Project. If
estimates under the Liabilities Approach result in initial gains, they are to be eliminated by a
margin and the consideration of expenses in determining that initial gain as basis of that
margin is limited to contractual expenses excluding any pre-issue cost, explicitly excluding
most of so-called acquisition cost.
Traditionally, insurance accounting intended to demonstrate specifically that the initial cost
expensed by entering into insurance contracts, which are mostly of unusual if not extreme
long durations compared with most other businesses, are covered by future expected earnings
even if recognizing a liability based on conservative assumptions, including sufficient
margins to ensure an adequate profit pattern as well subsequently. As a consequence,
acquisition cost are either deferred (Deferred Acquisition Cost Asset) or contractual
premiums, initial or subsequent, are reported at outset as revenue (Zillmerization or
prospective measurement).
The main reason for the difference in attitude is that now first time insurance accounting
guidance is developed with the intend of full consistency with other industries rather for
insurance purposes in isolation. General accounting guidance excludes consideration of preissuance cost, other than those spent to comply with contractual obligations. The Boards
decided, that as well insurance should follow the guidance in the Revenue Recognition
Project, not to recognize revenue before contractual obligations are performed, which is seen
as a general principle. This decision was made disregarding the severe distortions of
information resulting for reported income and equity of insurers, requiring a look to the notes
for the most relevant explanations. However, the Boards were not consistent in their
application of the principles found for Revenue Recognition: In case of subsequent
measurement they developed a deviating unique approach (except in case of short duration
contracts, where unearned premiums are required), where now this deviation causes severe
distortions of information. It is hard to understand the rational, that in one case a reputed use
of those formally applied principles even if this causes distortions is required and in the other
case an unmotivated willing deviation of the principles, as well causing distortions.
It could be assumed that good accounting principles are actually applicable everywhere
without causing distortions. There are following possibilities in the case that the application of
principles causes in special cases, here insurance, severe distortions:
1. The general principle is as well a suitable principle for insurance and initial revenue should
not be recognized to cover acquisition cost and the apparent distortions are actually reflecting
business reality.
2. The general principle is a suitable principle in general but there are specific circumstances
in case of insurance justifying an exemption from the principle or different or more
sophisticated interpretation is required, to recognize initial revenue to cover acquisition cost.
3. The general principle is not actually a principle but only – as an accounting compromise –
suitable in general and the circumstances in case of insurance are so deviating that applying
that compromise here would have definitely inadequate results. A proper principle-based
approach would result here in recognizing initial revenue to cover acquisition cost.
4. The general principle is not a suitable principle at all but the general approach does not
cause to much harm in the general case considering the normally trivial circumstances there.
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In case of the complex insurance business, the inadequacy of the general principle becomes
obvious since the complexity of insurance is the litmus test for any reputed principle.
Even the Boards discussed whether prohibition of initial revenue recognition is a principle or
a compromise, 1 but there was no clear outcome.
The General Approach in the Revenue Recognition Project
The Basics of the Revenue Recognition Project
The Revenue Recognition Project refers to contracts which require the reporting entity (the
producer) to transfer an asset to a customer.
Such assets could be goods or services. In a very abstract way, a good could be defined as an
asset, which is specific to the customer to whom it is transferred. It might be chosen out of
more or less large range of possible products of the producer and in so far relatively unique,
but it does not reflect any other peculiarity of the customer than this choice. It could be as
well transferred to any other customer, it is exchangeable. And, as a consequence, it could be
traded by nature. On the other hand, a service is an asset, which is specific to the customer to
whom it is transferred. It can only be transferred to that customer. Hence, it is not
exchangeable but fully unique, as unique as the customer is. By nature, it cannot be traded.
The customer might have a choice within a range of producers (providers) and some market
laws might apply, but the service itself cannot be traded in a market. Both, goods and services
can be specific to the producer. In so far, the producer remains distinguished, even if the asset
is transferred again and again (e.g. the issuer of a bond or the factory of a car).
In practice, transferred assets will be often combinations. E.g. equipment might be merely not
specific to the customer, but it is useless to the customer unless it is transported to the specific
site of the customer. Consequently, the transfer of the asset includes both, a good and a
service. Some equipment might be produced exactly to the specific needs of the customer, in
so far, although it might be a physical item, the production is a service.
To be tradable in a market, the asset needs to be exchangeable itself, i.e. a sufficient large
number of such items of an identifiably same quality need to be available. Consequently, real
markets exist only for artificial items like financial instruments, naturally produced items (like
bananas) or very trivial items (like screws), each of a defined quality, expressed as credit
rating of the issuer or other industry standards. For tradable items, the fact of actually being
actively traded is not a feature of the item but of its environment, i.e. whether there is
sufficient demand and offer of exchangeable items to cause an active market.
The Revenue Recognition Project excludes financial instruments. The rational might be that
financial instruments might be often exchangeable and therefore in theory tradable. However,
the most relevant feature of an asset for measurement is, whether it is actually traded or not,
since in the first case a market price can be determined reliably and more than that, the market
price is a relevant measure for an actively traded item – it can be exchanged at any time at that
amount. An item, which is not actively traded, disregarded whether it is formally a financial
instrument or not, cannot be reliably measured at fair value and the fair value might be even a
fully irrelevant amount, since transfer in a market is not a realistic alternative.
1
Para. 5-9 Agenda Paper 6B July 2008
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The Revenue Recognition Project refers to a given specific transfer, i.e. a contract which
requires the transfer and measures the activity within those specific circumstances. In so far,
the project refers to a specific transaction.
Most relevant is specifically the acquisition of the transaction. Here, there is a conceptual
difference between goods and services as defined above. Since a good is not specific to the
customer, the acquisition process is a pure sales process. The producer provides an offer (or a
given range of offers) and the customer can only choose within that and negotiate prices. The
production process is independent from the peculiarities of the customer and can be
completed, at least theoretically, before the individual customer is known. Hence, in case of
goods, there is a clear distinguishing between the production process of the asset to be
transferred and the acquisition process. In case of services, the production needs to occur after
identifying the customer, since the asset to be transferred, the service, is specific for the
customer. As a consequence, it is not possible to pre-produce services. But the acquisition
procedure might but need not to include production steps and might but need not to be a pure
sales process.
One of the purposes of the Revenue Recognition Project is to identify production activities of
the reporting entity to be distinguished from general activities and sales activities are seen as
such general activities, since they do not directly refer to a specific asset produced by the
entity.
The reference to a contract needs to be seen together with the definition of a contract in the
Discussion Paper: “A contract is an agreement between two or more parties that creates
enforceable obligations.” The reason for emphasizing contracts is not to exclude that revenues
are recognized for activities outside contracts, but to provide guidance how revenue is
recognized in case of contracts with a customer. 2 Hence, the focus is merely to differentiate in
such cases contractual and non-contractual activities. Pure sales activities, i.e. activities of the
entity, which do not contribute to the asset to be transferred but refer to establishing a
connection to potential customers by forwarding the offer to them, are not contractual
activities. However, wherever activities are under relationships which are based on
agreements between the parties (reporting entity and customer) and result in rights and
obligations, they are considered, disregarded their legal form and legal borders. Specifically,
one legal relationship could result in different economic relationships, e.g. different
performance obligations, or several legal but economically interdependent relationships can
result in one relationship from an accounting perspective. Specifically sequences of contracts,
i.e. where rights or obligations from one contract result in further rights or obligations created
or modified by a further agreement, cover altogether contractual activities but might affect the
timing of revenue recognition. The focus is not when does one contract end, is modified or
another starts but when is a performance obligation satisfied.
Measurement Attributes and Approaches
There are two main measurement approaches in use:
1) A pure prospective approach (asset-liability-measurement approach), where purely the
current net obligations or rights are measured disregarded any past cash flow. Such an
approach is the basis of IAS 37 and of the fair value measurement. Measurement attributes are
2
Discussion Paper 2.10
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current exit value, fulfilment value 3 or settlement value or a rational choice among those as
far as there are actually available alternatives 4. There are two sub-approaches:
(a) There is no guidance regarding the recognition of initial gains (advantageous difference
between transaction price and initial measurement) even for those cases, where the
measurement is subject to significant lack of objectivity.
(b) Initial gains are not to be recognized without positive evidence.
2) A merely retrospective approach (deferral-and-matching approach), where cash inflows,
specifically including past cash inflows, are associated with the performance under the
contract (often by matching with the cost incurred), typically associated with a requirement,
that the asset must not be larger or the liability not be lower than according to a prospective
approach (liability adequacy test). There are two sub-approaches:
(a) Transaction cost are considered as in IAS 18 and IAS 39.
(b) Transaction cost are not considered as in Revenue Recognition Project.
The pure prospective approach 1) (a) relies entirely in a principle-based manner on the
measurement. It assumes that the item can be measured on that prospective basis in a manner
that complies with the accounting qualities of the Framework. Typically, the measurement
attribute refers to an observed or potential (estimated) assessment by market participants.
Specifically in case of provisions, which occur without being part of an exchange transaction
(contract), there is no alternative to that approach. Without a consideration (transaction price)
received or paid, a retrospective approach is not possible, since a calibration of the margin to
the consideration as sole real-world value, which can be associated to the transaction in
absence of an active market, is not possible. However, in such cases any recognition of a
liability means a loss and objectivity requires limiting the loss to the amount positively proved
by evidence.
The sub-approach 1) (b) introduces already application guidance to overcome risks of
subjectivity and arbitrariness by requiring positive evidence. It establishes therefore a
reference to the transaction price, which might have lower relevance but is, as sole available
actually observed price, i.e. real-world value, of higher reliability than estimates without
adequate foundation on market price information.
It is important to note that IFRS distinguishes between transaction cost, which do not affect
the economic characteristics of the asset or the liability, like legal fees due in the course of the
transaction, and those cost, which actually affect the economic characteristics of the asset or
the liability, like transportation cost. 5 The latter add from the acquirer’s point of view to the
transaction price, since they are an additional transaction price for achieving the intended
modified economic characteristic of the asset or the liability. They result from the utilization
of the asset or the liability not from the specific form of the transaction, e.g. change in
ownership as in case of legal fees. From the seller’s point of view, such cost are a kind of
additional production cost to be spent to make the asset or the liability useful for anybody
else.
The retrospective approach 2) gives up to provide a real world measurement attribute but
simply refers to the transaction price as measurement basis. It is not longer the fall back
solution in case of lacking evidence. However, there are two views 6, view A identifying the
transaction price as negotiated price between the parties for the service and requiring revenue
3
For difference see para. 16 of Agenda Paper 7 B May 2008.
See IAS-E 37.36B in the version of the Exposure Draft as of January 2010
5
Compare IAS 41.9.
6
Para. 5-9 Agenda Paper 6B July 2008
4
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to be recognized as the performance obligation is satisfied by principle, while view B
understands such an approach only as a proxy in absence of a reliable measurement of the
more relevant fulfilment value. The IASB discussed the use of the current exit value in the
Discussion Paper Preliminary Views on Revenue Recognition in Contracts with Customers
and came to three reasons against it (the reasons are as well against any other prospective
value like e.g. fulfilment value):
(a) pattern of revenue recognition: As main reason, the discussion paper emphasized that “the
boards are uncomfortable with an approach that allows an entity to recognise revenue before
the entity transfers to the customer any of the goods and services that are promised in the
contract”, disregarded the fact, that in the prospective approach an adequate part of overall
profit is associated to the periods of performance by margins. That means, that the boards
believe that revenue should by principle be associated with goods forwarded or services
provided. A question to be discussed is what is so special in case of performance obligations,
to establish here such a principle, but e.g. not in case of financial instruments etc.
(b) complexity (including verifiability and lacking relevance): Considering the individuality
of performance obligations, the current exit price (and as well any other prospective
measurement) would require estimations and such a complexity and unavoidably lacking
verifiability would not be justified by the achievable improvement of information, since the
estimates would be in absence of active markets highly speculative and subjective. Further,
there is normally no intention and very often no possibility to transfer performance
obligations and a measurement attribute referring to a transfer is seen as counter-intuitive, i.e.
lacking of relevance (that argument does not hold against current fulfilment value).
(c) risk of error: Any initial gain reported or any initial revenue (that part of revenue not
needed to cope with obligations to be satisfied in future) is subject significantly to a risk of
measurement error. Considering the uncertainties of the estimation process it will be never
sufficiently clear, whether the obligation is covered adequately and whether all future risks
are covered in margins. Since the initial gain is difference between the (often even uncertain)
transaction price and the current value of the performance obligation, the entire estimation
error appears in the relatively small initial gain and it will never be clear, whether there is a
gain or simply an estimation error.
All the arguments, except that of lacking relevance in absence of intend or ability to transfer
the item, apply equally against a fulfilment value.
According to the current stage of the Revenue Recognition Project, revenue should only be
recognized as services under the performance obligation are provided, i.e. as far contractual
obligations (or legal obligations arising as a consequence of the contract) are fulfilled.
Consequently, revenue is not recognized to cover cost occurring which are not spent to
comply with contractual obligations, specifically cost arising in entering into the contract, as
far as they are not required to comply with contractual obligations.
General Approach: Reflection of a Traditional Accounting Proxy or a Principle?
The boards did not explicitly provide a decision between View A and View B of the July
2008 meeting. Reasons (b) Complexity and (c) Risk of Error are both pragmatic rather than
conceptual reasons, applying the traditional accounting response to those issues. That
response hesitates to recognize anything (both, advantageous and disadvantageous) as long as
it is still doubtful. To avoid that profit cannot be recognized before the entire contract is
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executed, a more objective and formal recognition is required, e.g. pro rata or in proportion to
cost or services provided. Specifically, in absence of any better workable solution in most
cases, accountants decided traditionally to prohibit the recognition of initial gains and to defer
the received consideration and match it with the provision of service or delivery of goods, as
proposed now again in the Discussion Paper.
In reason (a), the boards indicated lacking comfort with recognition of revenue before
anything is actually performed. However, as well that can be a merely traditional view, rather
than a conceptual argument. Clear is that the boards believe that revenue recognition should
reflect business activities which are closely related to the relationship with the customer and
merely “honour” those activities. At the end, the main question is not revenue recognition but
profit recognition. To be a useful information, it is important that the recognition of profits is
associated with the actual business activity rather than reported in a period as a result of
merely formal aspects like achieving agreement with the policyholder regarding the contract
This pure sales activity should not be honoured with the entire estimated profit from the
overall contract, specifically, if that gain cannot be realized easily in an active market for the
item. It can be assumed that the exclusion of pure sales activities from the profit recognition
process is the actual rational of the boards’ decision.
After all, it becomes clear that the principles of the revenue recognition project need to be
applied in a sensible manner to special cases, since it is not clear whether they are actually a
clean principle applicable in general.
Special Cases of the Revenue Recognition Principle
“An entity satisfies a performance obligation and, hence, recognises revenue when it transfers
a promised asset (such as a good or a service) to the customer. The boards propose that an
entity has transferred that promised asset when the customer obtains control of it.”
(Discussion Paper Revenue Recognition 4.59)
Special cases arise, if the asset, specifically a separate part of the entire service, is actually
provided before the contract is agreed by the parties. That applies e.g. if the service provided
is valuable only together with the contract and is a pre-condition to the contract and the
services provided there.
Such services provided in advance are often not referred to in the contract since they are a
pre-condition for agreeing the contract. Consequently, there is no need to mention them.
Further, since they become valuable for the customer only, if the contract is actually agreed,
there is no risk for the providing entity, that its services are misused. Typically, such services
are paid on a success fee basis, i.e. the payment is only due when the contract is actually
agreed and the payment might be included in the overall considerations as required to be paid
by the customer under the contract.
As starting point, a simple success fee based service is considered. There is a silent or oral
agreement, a non-written contract that a certain service is provided by the entity while a
payment, e.g. based on legal or orally agreed tariffs, if a certain success is achieved. There is
no doubt, that there is a contract with a performance obligation and under that contract normal
revenue recognition principles apply. Specifically, the consideration payable is uncertain until
the success is achieved and the measurement of that consideration follows the guidance for
uncertain considerations. However, typically it can be assumed that the performance
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obligation is satisfied when the success is achieved and therefore the consideration is
recognized at that time, often the end of the orally agreed contract.
More complex is the issue, if the success fee based (unwritten) contract is followed by a
subsequent contract, where the success fee is part of the consideration of the subsequent
contract. Here, the success is defined as the achieved agreement of the subsequent contract. In
such cases, it is first necessary to distinguish between a service provided and a pure sales
activity. For recognition of revenue it is actually necessary to provide a service in advance
which is completed when the subsequent contract is agreed. It needs to be clear to the parties
that the remuneration for the prior service is covered on a success fee basis with the
consideration of the subsequent contract. In that case the unwritten prior contract is integrated
in the subsequent, typically written, contract and this continuation needs to be considered as
well in revenue recognition.
Further, it is necessary to exclude any activity simply resulting from the transaction itself, e.g.
legal activities in transferring legal ownership rights (transaction cost). As well those are not
an asset transferred by the entity to the customer.
Distinguishing Production Activities, Sales Activities and Transaction Activities
Key for the question when to recognize revenue is the degree of satisfying of the performance
obligation. However, in case of multiple performance obligations, either multiple delivery of
goods or permanent rendering of services, or a mixture, the relative associated proportion of
the consideration of the customer will be determined normally based on the value of delivered
goods or rendered services. That value is determined considering those cost needed to
produce the good or the service.
The different character of activities ultimately results from the issue, whether they are
incurred to satisfy an obligation or not.
•
Production activities are those which are incurred to satisfy an obligation, while other
activity types aren’t. Production activity are those, which cause that a good or service
is achieved in that form as it is demanded by the counterparty in paying the
consideration.
•
Sales activities are activities simply to bring both parties together and to bring in line
their intentions, specifically the price, without actually affecting the good to be
delivered or the service to be rendered. Since sales activities do not satisfy a demand
of the customer, their kind and volume is entirely at the decision of the entity. They do
not influence the delivery of goods or rendering of services wherever a performance
obligation exists or future performance obligations. They simply influence whether
performance obligations come to existence or not. In so far, they have the character of
overhead cost.
Sales activities could produce an asset (e.g. a customer relationship asset) but that
asset is not the asset which is the object of the relationship between the parties, for
which the counterparty pays the consideration. Specifically, if the sales activity is
provided by a third party, as reporting entity, to a producer/service provider or its
customer, that relationship between the third party and the respective contract party is
a service (outsourcing of sales activity).
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•
Transaction activities are to proceed the transaction but do not affect the economic
characteristics of the good or service to bring them in line with the demanded
characteristics. Economic characteristics are those which affect the ability of a party to
make economic use of an asset. Ownership e.g. is not economic characteristic and
consequently transaction fees are not production cost, since somebody can make use
of an asset although he does not legally own it, it could be ceded, rented or however
made available without changing ownership, i.e. transaction cost result from the
specific legal form of the transaction.
Hence, production activities trigger revenue recognition, although the timing of revenue
recognition might be later than spending the related cost, e.g. not earlier than the contract is in
force. If considerations are payable in future would be qualified as an asset, revenue can be
recognized even before those considerations are due.
Examples
Example 1
A car factory provides an offer for a car including a variety of car features resulting in a
theoretical number of possible combinations of 1 million. Consequently, it is not likely that
one car is alike the other, the cars are “customized”. However, the cars are not “customerspecific”, they are just a choice within a given range of alternatives in the production process.
The car dealer provides advisory to the customers which of the 1 million pre-defined cars, as
implemented in the existing production process, to choose. But the production process of the
car is not affected by the sales people. Theoretically, the car factory could produce the 1
million cars and deliver that car chosen by the customer. That shows that the activity of the
car dealer is not a part of the production process of the car factory but a sales activity.
Consequently, the contract with the sales people is an own and separate business activity,
even if they are paid via commission by the car factory, ultimately paid by the price the
customer pays for the car.
Example 2
Consider a group of painters cooperating by founding an organization (“the organization”) to
do the preparatory work for their job. The organization looks for customers who want to have
their walls painted. It identifies the wall, the area around it, organizes a date and that the
working place is prepared, that material (owned by the painter) is on site in time etc. All that
is not paid by the customer directly to the organization but the painter, who gets the job, pays
the organization. The customer only pays the usual price (which includes in case of normal
painters all such preparatory work) to the painter. However, the contract is signed when the
painter appears on site, not mentioning the preparatory work (since that is already finished),
and the price is paid immediately in its entirety in one amount (as well in advance for the
subsequent painting). Before that, both, the painter and the customer can refuse to accept the
contract. All the work of the organization is only paid if there is success. Here the group of
painters organized a service to the customers, which is an integral part of their work to be
done. It is not useful for the customer, except if the contract is actually agreed, but in that case
it is a necessary part of the production of the service intended by the contract (the painter
cannot paint the wall without the preparatory work being done). It is not possible to preproduce here anything, since the preparatory work specific to the wall of the customer.
Consequently, it is not possible to distinguish the work of the organization from the service
provided by the painter. It is ultimately one contractual relationship covering one piece of
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service provided partly in advance on a success fee basis, partly subsequently to agreement of
the contract, but all paid together for the integrated service activities together. There is no
clear conceptual distinction between that what is done by the painter and that what is done by
the organization. The unwritten contract between the customer and the organization becomes
an integral part of the subsequent contract between customer and painter. However, that might
have no accounting consequences, since the performance obligation is in any case satisfied, if
the entire wall is readily painted and therefore revenue would be recognized in any case at the
end of the contract. But if we assume that the parties agree in the contract between customer
and painter, that the painter paints two further walls at the premise, revenue for the first wall
would be recognized after finishing that first wall plus the revenue for the entire preparatory
work. The latter would not be allocated to all the three walls, since it refers only to the first
wall and the preparatory work for the other walls needs to be done by the painter himself.
Example 3 A
Assume a factory intending to acquire a large machinery from a producer to be used within a
certain (industry-wide used) process in the factory. Before signing the contract the factory
wishes the proof that the machinery works well together with the other equipment in that
standard process. Therefore, the producer of the machinery establishes a model plant with the
same process and transports the machinery to that place to demonstrate that it works well to
the factory and other customers. If the factory is satisfied, the contract is signed (clearly
considering in pricing all the sales and overhead cost of the producer as far as achievable, and
requiring the transport to the factory) and the machinery is transported to the factory. The
producer can do with the model plant and the machinery there what it wants, e.g. using it for
other customers. Here, the transportation of the machinery to the model plant is only a sales
service, not an integral service of providing the machinery to the customer.
Example 3 B
Assume a factory intending to acquire a large machinery from a producer to be used within a
certain process in the factory. Before signing the contract, the factory wishes the proof that the
machinery works well together with the other equipment on site. Therefore, the producer of
the machinery has to transport the machinery to the factory and install it here. If the factory is
satisfied the contract is accepted (not mentioning the transport, since it did already occur) and
the machinery remains there, otherwise the producer has to take it away on own cost. Here,
the transportation is paid on a success fee basis referring to the acquisition of the machinery
(not to the success of the transport) together with the total cost of the machinery. The actual
transportation cost are not simply charged to the factory but, since there is a risk within any
success-fee-transaction, it is part of the overall pricing of the machinery, considering in a total
calculation as well that risk. The transportation is done by a haulage contractor, directly paid
by the producer. Here, a part of the overall service is already provided when the contract is
signed and revenue for that part of service can be recognized at once. The price of the
machinery itself cannot necessarily be recognized at once, if e.g. further modifications are
needed for the machinery on site to have all required features.
Example 4 A
A snowmobile company in Germany offers 3 week trips in Canada over year end. Precondition for booking such a trip is to have a 2.25 hour snowmobile lesson (2 hours theory
and a quarter hour driving in a skiing hall) in a nearby mountain area in Germany free-ofcharge (the travel to that place is at the cost of the customer and overall the training will cost
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the customer a day). If the company is convinced that the customer is able to drive a
snowmobile, it is willing to accept the contract. The contract itself does not mention the
training, since it is to be made in advance. Clearly, the price for the trip is calculated in a
manner that it covers the training and as well those cases, where the customer turns out to be
unable to drive such a snowmobile or decides not to make the trip. However, it is expected
that in nearly all cases those customers able to drive a snowmobile will book as well the trip,
since they accepted a lot of trouble to take the lessons without any other benefit than being
permitted to book the trip. The training is part of the production process of the 3 week tour,
since otherwise the training would have to take place at the begin of the tour. Consequently,
the company would recognize revenue for the training already at year end, not distributing it
over the entire three week trip. Modifications of the example could mean that the tour would
be permissible without training but at a higher price (i.e. the training actually results in a
financial asset transferred to the customer).
Example 4 B
Segway offers a free 5 minute trip under supervision in a pedestrian area. The vehicle can as
well be rented for longer at a charge but without supervision, but only after having the 5
minute trip under supervision free-of-charge before. A lot of persons try just for fun the
supervised free short trip without the intention to make a longer trip. Segway hopes as well,
that people will be motivated to buy the vehicle rather than making only the longer paid trip
immediately. For both offers the initial trip is not mentioned in the contract. Clearly, the
initial supervised trip is a sales activity (marketing). It does not affect the subsequent contract,
although it might be a pre-condition for the longer paid trip. But it is a value itself for the
people like any free sales gift.
Consequences
In case of more complex contractual agreements, specifically of sequences of unwritten and
written contracts, the first one on a success-fee basis, the revenues need to be associated to the
services provided, which need to be distinguished from sales activities.
Important is that the success-fee based service is actually only of use for the customer, if the
subsequent contract is accepted. Otherwise, it would be a marketing gift.
If services in advance result in the fact that the prices in the contract are overall cheaper (e.g.
in the modification of the example 4 A, since the additional insurance premiums of the
snowmobile trip for untrained customers might be higher than the cost of training), there is
actually an asset transferred at the begin of the contract, not only in proportion as the
subsequent services are provided, since the customer acquires a right already at outset at a
lower price than otherwise charged.
The fact that the service under the first unwritten contract is not mentioned in the subsequent
contract, which determines the consideration payable, does not mean that it is not a
contractual service under the overall contractual arrangement. The first unwritten contract is
economically and legally an integral part of the subsequent contract and there is no need for
accounting purposes to refer to the services of the first contract in writing to allow revenue
recognition.
There might be important reasons to do some of the production work for an in principle
willing customer-to-be before the contract is ultimately agreed. Before the price can be
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determined a lot of peculiarities of the customer-to-be have to be investigated. That means as
well a lot of effort for the customer-to-be (to have the wall or the health examined). Both
parties will spend that effort only, if they are principally willing to agree the contract. The
moment, where the contract is actually agreed is not relevant from an economic point of view.
Some parts are paid in arrear on a success fee basis, others are paid in advance. But that is not
a difference of the service provided but only a formal aspect.
To cope with such situations properly, under the Revenue Recognition Principle the contracts
are considered together and revenue is as well recognized for services provided in advance
under the first unwritten contract, if the respective asset is transferred.
Consequences Drawn Tentatively from the Revenue Recognition Project in the
Insurance Contracts Project
The IASB and FASB tentatively decided that no revenue should be recognized at outset to
cover initial cost. The reasoning was:
“The insurer should recognize revenue only when it satisfies its performance obligations to its
customer (the policyholder) under the insurance contract. At inception, the insurer arguably
has not satisfied any of its performance obligations under the contract, so no revenue (or
income) is recognized.”
The entire difference between the present value of future cash inflows and of future cash
outflows under the contract as determined at outset plus a risk margin for any inherent
deviation risk in those cash flows should be deferred by recognizing an additional residual
margin within the liability, distributed over the entire coverage period of the contract in
proportion to the performance of the contractual obligation.
The consequences could be grave if not dramatical, and the usefulness of the entire report of
the insurer can be doubted.
Example
Assume a single premium deferred life long annuity without surrender right and no death
benefit. The life long annuity starts 20 years after outset if the insured survives that time
(otherwise nothing is paid at all) and is paid until death. The single premium is 100,000 CU
paid at contract inception, acquisition cost are 5,000 CU. The current estimate of future cash
outflows plus risk margin is about 94,000 CU. According to the tentative decision, the initial
liability is measured at 100,000 CU, including a residual margin of 6,000 CU. Since there is
practically no service during the first 20 years, the main part of the residual margin is released
during the annuity payment phase after 20 years, distributed again over the next 40 years.
Consequently, the reduction of equity as a result of paying 5,000 CU acquisition cost would
be recovered mainly not earlier than 30-40 years after spending those amounts although the
covering premium was irrevocably received at outset. That specifically means that the
acquisition cost of the new business of e.g. about 2 or 3 decades would reduce the equity
shown compared with the situation today by overstating the liability with a residual margin
which entirely covers the acquisition cost. A normal insurer, offering such business, would
report permanently heavily negative equity and a heavily overstated liability. Although that
might be explained in the notes, the typical key information of the balance sheet is heavily
distorted. Considering that in many markets profit margins from life insurance contracts are
very small (specifically in case of participating business), the relationship between the
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pretended losses from acquisition cost and the actually expected profit is misleading for the
users of the report.
Accounting Issue
The boards correctly asked the question, although accepting, that the issue is in case of such
extreme contracts of specific severity, which specific circumstances in insurance justify to
report revenue at outset, while all other industries have to defer revenue although intended to
cover pre-issuance cost. Assuming that the acquisition cost are spent for sales activities, there
is no reasoning to consider those, disregarded, whether those sales activities are paid on a
success-fee basis to be covered by the revenues from the subsequent contract.
Application of the General Principle in Case of Insurance Contracts
The Role of the Insurance Pool: The Business Model of Insurers
Insurance is not only transfer of risk, it is a permanent service of providing coverage
capabilities and capacities by maintaining an insurance pool, which distinguishes insurance
from a simple bet. An insurance pool of a sufficiently large number of sufficiently
uncorrelated and homogeneous risks mitigates mightfully the deviation risk of the individual
risks according to the Central Limit Theorem. The basic form of insurance is a mutual
company providing insurance at cost – although the mutual does not bear any risk itself, it
organizes the insurance pool and the members share the residual risk after pooling mutually.
Policyholders benefit from taking insurance by acquiring protection for a price which is lower
than their own opportunity cost of their risk without insurance, since pooling reduces actually
the deviation risk causing otherwise severe opportunity cost.
Insurance is a stand-ready obligation to provide compensation in case of the insured event. To
be acceptable, the insurer needs to demonstrate that it actually has the capability and capacity
to stand ready in such a case. There is a significant difference for a customer in accepting a
service offer, whether a painter is able to paint a wall or whether an insurer is able to provide
coverage. While a painter might be able to achieve the needed capabilities after signing the
contract, an insurer needs to have a suitably sized pool and sufficient capital at outset, since
that cannot be achieved fast, even more, the insured event could happen immediately after
outset. The permission to transfer an own risk to an insurance pool is therefore already a
benefit for the customer. Therefore, customers are willing to pay for that permission, as far as
the charge for entering into the pool is lower than the reduction of opportunity cost by
insurance.
Risk types are not insurable, if the cost of aggregating those risks to a pool are higher, than
the resulting benefit from mitigating the deviation risk. Depending on the severity of the risk,
the pool needs to have a certain size and homogeneity. In absence of a sufficient number of
such risks available at adequate cost, the pooling effect will be to low.
Consequently, the process of aggregating such pools is the most important business activity of
insurers regarding their basic function to pool risks.
The obligation to the policyholder
Taking insurance, the policyholder acquires a right to coverage for a specific time. The
policyholder is not only serviced permanently during that time, the policyholder has acquired
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a right of future coverage already at outset. The insurer has the obligation to be at that time in
the state to be able to provide that coverage and has the ongoing obligation to remain in that
state, since the obligation is to stand ready. That means that the insurer has to uphold the pool
since without the pool the insurer is not able to meet the promise given and that is a violation
against the contractual obligations already before the insurer is actually unable to meet a
claim occurred.
Being permitted to enter the pool is a financial advantage and the right is consequently an
asset. E.g. if a good is insured, its value of the entity would immediately increase. That asset
is transferred to the policyholder by permitting to enter the pool. Being member of the pool is
not trivial – specific requirements of homogeneity and independence in comparison to the
risks already in the pool need to be met. And that compliance is achieved by the services in
the acquisition procedure. Hence, the asset resulting from the right to enter the pool is
transferred by the acquisition process.
The transfer of an asset at outset can be demonstrated with several examples: The fact that the
insurer promised coverage for a certain time is sufficient to get a loan on the insured house or
car, it allows to buy a house on a life-lease basis by using a life-long annuity on the life of the
owner (that applies even to a contract usually without intensive health examination).
Sometimes, insurers offer choices to buy life insurance at higher premiums but with a
shortened health examination, showing on the other side, that an intensive health examination
causes the right to take insurance at lower rates. The customer assesses control of the asset at
outset, since the insurer grants the irrevocable right to get coverage for a specified period. As
the examples before demonstrate, the customer can make immediately full economic use of
the promise itself and does not need to await the coverage provided over time.
Peculiarities of Initial Cost in Case of Insurance Contracts
The acquisition procedure of insurers contains following steps:
1. Potential customers need to be found (searching for contacts).
2. The individual risk exposure of potential customers has to be investigated, including
correlation to other risks already covered by the insurer (risk investigation).
3. The resulting coverage demands have to be brought in line with the coverage provided in
the existing pool to maintain homogeneity (negotiation of risk exclusions or inclusions) and
the specific coverage to be defined.
4. The resulting position has to be verified and confirmed by the underwriting department
(acceptance).
5. The contractual position has to be documented (issuance).
Step 5 is usually a contractual obligation of the insurer; the policyholder is in many
jurisdictions legally entitled to receive a policy document after acceptance.
Step 2 to 4 are customer- and insurer-specific. They refer to the risk peculiarities of the
specific customer and the specific individual coverage offered by the insurer. That is the
difference to buying a TV-set. You can get the advice in a specialized shop and buy via
internet, since it is the same TV-set. But that is not possible here. The specific insurance
product can only be acquired at the negotiated price at the specific insurer, there is no
alternative. Further, the definition of the specific risk to be covered, i.e. the asset to be
transferred, is constructed here.
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Step 1 appears similar to any other industry searching for customers. However, most
industries, except direct selling companies, typically merely await that customers come to
them. But for insurers, new customers are not only a source of profit in distributing their
products but – to achieve a pooling effect – the pre-condition to do business at all, since the
volume of customers itself, the pool, is the good produced. Therefore, searching potential
customers is not primarily a sales process but as well a production process and a service to all
customers acquired in a period together commonly. To be able to produce for each individual
case the demanded coverage, the insurer needs first a pool.
Accounting Considerations
The relationship between the policyholder (customer) and the insurer is formally split in two
legal relationships, the unwritten contract of the acquisition stage and the actual insurance
contract. The first contract is an agreement between the customer (here policyholder-to-be)
and the insurer, either directly or partly indirectly involving as well an intermediary.
However, the intermediary acts clearly on behalf of the insurer. The agreement includes that
insurance coverage is styled reflecting the specific needs of the customer and the result
enables the customer to enter its risks into the pool of the insurer. It is agreed, that service is
paid as a success fee integrated in the premium charged for the subsequent insurance contract.
The insurance contract grants the customer that its risk as assessed and identified under the
first contract enters the pool and that coverage is promised for a specified period, the insurer
upholds its claims payment ability and compensates actually occurred insured claims.
Although the second contract usually does not repeat the rights of the customer under the first
contract (except in one case known, i.e. Germany), it refers to the outcome of the first
contract, specifically requires that all information forwarded by the customer in that process
has to be true, otherwise the coverage would be void. It refers to the specific risk as assessed
and identified in the first contract. However, there is no need to mention that in the insurance
contract, since the insurance contract is not agreed without the first contract being fully
satisfied. Just the consideration is paid, since there is success, as part of the premium under
the insurance contract. Considering the interdependency of both contracts, from an IFRS
position they need to be seen as one contractual relationship, formally realized in two legal
steps, which do not reflect the substance of the relationship.
At inception of the insurance contract, the insurer transfers an asset to the customer based on
the work completed successfully under the first (unwritten) contract before and paid by the
premiums due under the insurance contract. The asset is the right to bring the assessed and
identified risk into the pool and get a promise of coverage. This asset is achieved by the
service provided under the first contract and the customer has now taken control of that asset.
The promise of the insurer is now binding and the customer can make use of it.
The advisory activity before the contract is agreed is an integral part of the product. The
product, i.e. the coverage of the specific risk of the customer, is tailor-made for the customer
and that occurs in the advisory process. The product, the insurance contract is actually
developed in that process rather than a given contract is simply forwarded. The customer does
not choose within a range of available products. The customer’s own specific risk is made to
the product, i.e. the product is directly derived from the individual customer. The fact that the
majority of wording in the contract is fixed, should not cause confusion: The decisive part in
an insurance contract is the specification of the individual risk covered and those are
developed and identified in the advisory process.
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The acquisition process is a service provided to the customer on behalf of the insurer. The
insurer is not only liable for mistakes there (culpa in contrahendo) but the agent is normally
acting on behalf of the insurer. Even more, making use of the services by the agent, the
customer agrees implicitly that the service is paid by means of the premiums paid later to the
insurer. The customer cannot make use of the advice received in any other way than taking
insurance with the insurer providing those services through its agents. Economically, the
customer has a contract with the agent, agreeing that the compensation for the services with
the agent is paid in form of a success fee, i.e. a fee chargeable only if the service results in an
insurance contract. And it is agreed, that the fee is paid within that insurance contract by
means of premium payment. The agent is compensated directly by the insurer. Economically,
the insurance contract includes the prior service provided by the agent and specifically the
compensation for that service.
Some might argue that this is true for any sales activity. However, the difference is, that the
acquisition activity in case of insurance (i.e. reflecting the individual risk of the customer) is
part of the production process, while in other cases it is an own separate process. The
difference can be described by examples:
The acquisition process is not a pure sales process. Bringing customer and insurer together is
only one aspect of the entire activity. The intermediary plays an important role in the
production process of the insurer to maintain the pool. Considering that importance, the
undividable activity should be understood in its entirety as an activity directed to provide the
service of gaining coverage. Since, in difference to most other industries, the production
character is significant, the activity should be in case of insurance be treated in its entirety as
production activity. Only explicitly identifiable sales activities like pure marketing cost,
advertisement etc, as long as they are not varying with the new business of a period (like
mailing activities of direct sales insurers), should be excluded.
Further, the acquisition process does not purely mean transaction cost, since it deals with the
economic substance of the asset transferred. There are practically no transaction cost in case
of insurance. In some cases, it might be necessary to involve authorities or to forward fees,
taxes or charges to authorities. However, those are not included in that what is referred to the
acquisition process.
Accounting Consequences
In the language of the Revenue Recognition Project, the performance obligation to bring the
risk of the customer into the pool and to provide a coverage promise for a specified period is
satisfied at contract inception. A valuable asset is transferred to the customer. The
consideration included as a success-fee in the insurance premium is therefore now to be
recognized as revenue at outset of the second contract. No revenue is recognized during the
first contract since no performance obligation is satisfied. However, the revenue recognition
at the inception of the second contract is for the first contract and reflects that part of
consideration received under the terms of the second contract, which is the success-based
uncertain consideration of the first contract.
However, if the approach in the Revenue Recognition Project is seen as a principle, the part of
the consideration recognized at contract inception as revenue should include as well a part of
the profit margin. That would result in recognition of a profit for the acquisition procedure.
But if as well the concerns regarding initial profits are considered, i.e. the approach of the
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Revenue Recognition Project is seen merely as a pragmatic solution, revenue should only be
recognized up to the amount of cost incurred varying with the total new business of the
period. It is actually not determinable in an objective and verifiable manner what the total
profit is and which part belongs to the activities of the first contract.
The findings apply in the first instance to single premiums or legally enforceable premiums
(e.g. if the single premium is paid in instalments which are legally nevertheless due at contract
inception). Further investigations are needed, if the considerations are uncertain, i.e. regular
premiums where the policyholder has some options to cease premium payment prematurely.
Most important, the findings apply only to insurance contracts, i.e. contracts with significant
insurance risk. For e.g. investment contracts, the acquisition process is no part of the
production process, since a pre-produced financial instrument is simply sold. The product is
not customer-specific. Product inception does not mean to transfer an asset. However,
exemptions might apply for some forms of investment contracts with performance-linked
obligations, if the policyholders actually are permitted to enter into an existing pool of
investments. The right to enter such a pool and to invest money there might be a valuable
asset. But that question is not subject of this paper.
Acquisition Process as Transfer of Business
To some extent, the acquisition process means to bring potential policyholders and the insurer
in contact and to create a basis for granting coverage on that basis. Ultimately, there is little
difference between that what the insurer acquires from the intermediary and that what the
insurer acquires when a portfolio is transferred from another insurer. The difference is only
formal, since in the first case the insurer agrees formally to the contracts individually, while in
the second case the insurer becomes collectively party to the contracts. However, that
difference does not really matter since the collective business approach of the insurer means
that contracts are not actually individually accepted but the insurer has a clear and
systematically applied acceptance policy, which means that any proposal within the defined
range is accepted if the result of the first (unwritten) contract indicates adequate insurability.
E.g. under US-GAAP, the “value of acquired business asset” has the same function for
acquired portfolios as the “deferred acquisition cost asset” has for directly written business. In
both cases, the cost of the reporting entity in entering into the contracts (disregarded that they
existed before already in relationship to another insurer in the first case and that insurer is
now remunerated for transferring the position of the insurer’s party under those contracts) are
capitalized. From the view point of the reporting entity, in both cases fully new contractual
relationships are created for a price paid to a third party.
Consequently, the consideration even of the sales part of the acquisition process, as far as
externally provided, should be accounted for consistent with a transfer of business. The price
paid, normally the commission, would be capitalized. Since this approach would have a
similar effect as the approach described above, but limited to the external relationship to the
intermediary, covering the main part of the sales activity, it is reasonable to prefer that the
Revenue Recognition Principle is applied to the entire (variable) acquisition cost, without
distinguishing between sales and production parts.
February, 25th 2010
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