How will IFRS 10 impact third party cell captive arrangements?
Issued in 2011, IFRS 10 is applicable for annual periods beginning on or after 1 January 2013. The new consolidation standard, IFRS 10 Consolidated Financial Statements (IFRS 10), may impact the accounting of third party cell captive arrangements. We will explore to what extent it will impact the cell insurer.
An entity is required to own an insurance licence to provide insurance products to the public. The Financial Services Board is the regulator of this industry and requires compliance with numerous regulations. Entities, in other industries, for which it may be difficult and burdensome to obtain an insurance licence, may enter into cell captive arrangements with insurers. The entities use these arrangements to provide insurance products to their clients, effectively using the insurer’s licence.
A typical third party cell captive arrangement in the South African environment
A registered insurer (cell insurer) and an entity will enter into a subscription agreement. The entity subscribes for shares (ordinary or preference) issued by the cell insurer to “purchase” the cell. The entity becomes the cell owner and through the agreement, it will be able to offer insurance as a complimentary product to its clients. The subscription price will initially provide capital to the cell.
The cell insurer will administer the cell and charge the cell an administration fee. The cell insurer will underwrite the insurance policies. The insurance contract will be between the cell insurer and the client. Therefore, the cell insurer will be legally responsible for any claims submitted by the clients.
The cell owner will collect the insurance premiums from the clients and pay them to the cell insurer, which will allocate the premiums to the cell.
The cell insurer allocates assets to the cell which are legally in the name of the cell insurer. If these assets are insufficient to settle claims received from clients, the cell insurer has to contribute cash to meet these obligations. The cell insurer then has the right to require the cell owner to recapitalise the cell, generally through a further subscription of shares. In the event that the cell owner is unable to provide further assets to the cell, the cell insurer will suffer the loss.
The cell owner is entitled to excess profits in the cell, i.e. any residual in the cell after claims have been paid. During the life of the arrangement the cell insurer, at its discretion, may distribute the profits in the cell to the cell owner in the form of dividends. On termination of the agreement, the cell insurer is required to redeem all the shares held by the cell owner. Generally, it will be at a price based on the net asset value of the cell.
The assets and liabilities of the cell are ring-fenced and cannot be utilised for other cells in the cell insurer. However, in the event that the cell insurer is liquidated, the cell’s assets are not protected from the cell insurer’s creditors. Previously (before the application of IFRS 10), the cell was seen as a special purpose entity separate from the insurer, controlled by the cell owner. As a result, the cell was “extracted” from the cell insurer and consolidated in the cell owner’s consolidated financial statements.
With the introduction of the new consolidation standard, IFRS 10, will this outcome change?
The new single control model at a glance
The objective of IFRS 10 was to develop a single enhanced consolidation model applicable to all types of entities or portions of entities. It supersedes IAS 27 Consolidated and Separate Financial Statements and SIC 12 Consolidation – Special Purpose Entities.
This new standard is effective for entities with financial reporting periods beginning on or after 1 January 2013. In terms of IFRS 10, an investor controls (and therefore should consolidate) an investee when the investor has power over the investee, is exposed, or has rights to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.
An investee can either be a separate legal entity or a deemed separate entity. The deemed separate entity is often called a “silo”. A silo is effectively a “division” or a “branch” of an entity. All the assets, liabilities and equity of such a deemed entity are ring-fenced from the overall entity.
The cell is not a separate entity from the cell insurer, as the insurer is the legal entity. Therefore, we will assess whether the cell meets the definition of a silo, i.e. can it be seen as a ring-fenced entity separate to the cell insurer.
Does the cell meet the definition of a silo?
Based on the typical characteristics discussed for the third party cell captive arrangement, the cell’s assets and liabilities are separately identifiable. However from a legal perspective, the cell and the cell insurer are not seen as separate. The assets of the cell insurer have to be used to settle the claims of the cell if there are insufficient funds within the cell, as the insurance contract is between the cell insurer and the client.
In addition, if the cell insurer is liquidated, the assets of the cell will not be protected from the cell insurer’s creditors. Therefore, the cell does not meet the definition of a silo, as the claims from clients are potentially not only paid from the cell’s assets. This conclusion may not be the same for all third party cell captive arrangements, as different subscription agreements, facts and circumstances may change the conclusion.
If the cell meets the definition of a silo, a control analysis in terms of IFRS 10 would need to be performed to determine who controls the cell. The party that controls the cell would consolidate it in its consolidated financial statements. In our scenario, the cell will remain part of the cell insurer. As a result of this conclusion, we will consider how the cell insurer should account for the subscription agreement with the cell owner.
Cell insurer’s accounting treatment of the subscription agreement
It should be considered whether the subscription agreement should be accounted for as a reinsurance contract by the cell insurer. A reinsurance contract would transfer significant insurance risk from the cell insurer to the cell owner. One could argue that the cell owner could be exposed to financial risks (for example credit risk of the cell insurer). IFRS 4 insurance contracts (IFRS 4) states that a contract may expose an insurer to insurance and financial risk. If the significant risk is insurance risk, the contract is recognised as an insurance contract. If not, the contract is accounted for as a financial instrument in terms of IAS 39 financial instruments: recognition and Measurement (IAS 39)(or IFRS 9 financial instruments (IFRS 9).
It could also be argued that the cell owner is merely recapitalising the cell as it would have recapitalised any of its business operations when the operations were making losses. As a result, no reinsurance contract is recognised but a financial instrument in terms of IAS 39 (or IFRS 9) is recognised.
Based on the discussions above, IFRS 10 may have an impact on cell insurers. In a South African environment, the cell will no longer be “carved-out” from the cell insurer and consolidated into the cell owner’s consolidated financial statements, as it does not meet the definition of a silo.
Cell insurers should carefully consider the accounting of the third party cell captive subscription agreements. The cell insurer should consider whether it should recognise these agreements as a reinsurance contract or a financial instrument.