Question and answer from Study Hub, IAS 19.

Activity 1 Nature of a Pension Plan
Molise Co’s pension plan was accounted for as a defined benefit plan in 20X8.

During the year ended 30 April 20X9, Molise changed the accounting method used for the scheme and accounted for it as a defined contribution plan, restating the comparative 20X8 financial information. The effect of the restatement was significant.

The 20X9 financial statements explain that, during the year, the arrangements underlying the retirement benefit plan had been subject to detailed review. Since the pension liabilities are fully insured and indexation of future liabilities can be limited up to and including the funds available in a special trust account set up for the plan, which is not at the disposal of Molise, the plan qualifies as a defined contribution plan under IAS 19 Employee Benefits rather than a defined benefit plan.

Furthermore, the trust account is built up by the insurance company from the surplus yield on investments. The pension plan is an average pay plan in respect of which the entity pays insurance premiums to a third-party insurance company to fund the plan. Every year 1% of the pension fund is built up and employees pay a contribution of 4% of their salary, with the employer paying the balance of the contribution. When employee leave Molise and transfer their pensions to another fund, Molise is liable for, or is refunded the difference between the benefits each employee is entitled to and the insurance premiums paid.

Required:

Discuss how the pension plan should be accounted for in the financial statements of Molise for the year ended 30 April 20X9.

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Molise’s pension arrangement does not meet the criteria as outlined in IAS 19 for defined contribution accounting on the grounds that the risks, although potentially limited, remained with Molise. Molise has to provide for an average pay pension plan with indexation limited to the amount available in the trust fund. The pension plan qualifies as a defined benefit plan under IAS 19.

The following should be taken into account:

The insurance contract is between Molise and the insurance company, not between the employee and the insurer; the insurance contract is renewed every year. The insurance company determines the insurance premium payable by Molise annually.
The premium for the employee is fixed and the balance of the required premium rests with Molise, exposing the entity to changes in premiums depending on the return on the investments by the insurer and changes in actuarial assumptions.
Under the insurance contract, when employees leave Molise and transfer their pensions to another fund, Molise is liable for, or is refunded, the difference between the benefits each employee is entitled to, based on the pension formula, and the entitlement based on the insurance premiums paid. Molise is therefore exposed to actuarial risks (i.e. a shortfall or over funding as a consequence of differences between returns compared to assumptions or other actuarial differences).
There are the following risks associated with the pension plan:

Investment risk: the insurance company insures against this risk for Molise. The insurance premium is determined every year; the insurance company can transfer part of this risk to Molise to cover shortfalls. Therefore, the risk is not wholly transferred to the insurance company.
Individual transfer of funds: on transfer of funds, any surplus is refunded to Molise while unfunded amounts have to be paid; a risk that can preclude defined contribution accounting.
The agreement between Molise and the employees does not include any indication that, in the case of a shortfall in the funding of the plan, the entitlement of the employees may be reduced. Consequently, Molise has a legal or constructive obligation to pay further amounts if the insurer did not pay all future employee benefits relating to employee service in the current and prior periods.
Therefore, the plan is a defined benefit plan.

My Question:

Could you please explain both the question and the answer? It carries a lot of terms and concepts related insurance that I’m unfamiliar. It can’t understand both the question and the answer and would appreciate your help in understanding them both. Thank you in advance.