In a distant kingdom, many years ago, the International Accounting Standards Board (IASB) wanted to achieve consistent accounting for all insurance contracts by all companies around the world (although the US has opted out and US GAAP will persist), to enable comparability with non-insurance products. In May 2017, the International Financial Reporting Standard (IFRS) 17 on Insurance Contracts was released with an effective date of 1 January 2021, with prior-year comparative reporting required.
Although IFRS 17 will by all accounts have widespread consequences for (re)insurers, and many firms are preparing for significant changes to their business operations, the benefits of comparability and increased transparency will give users more insight into an insurer’s financial health.
Scope
An entity shall apply IFRS 17 Insurance contracts to:
- Insurance contracts, including reinsurance contracts it issues;
- Reinsurance contracts it holds; and
- Investment contracts with discretionary participation features it issues, provided the entity also issues insurance contracts.
Some contracts meet the definition of an insurance contract but have, as their primary purpose, the provision of services for a fixed fee. Such issued contracts are in the scope of the standard, unless an entity chooses to apply to them IFRS 15 Revenue from Contracts with Customers, and provided the following conditions are met:
- The entity does not reflect an assessment of the risk associated with an individual customer in setting the price of the contract with that customer;
- The contract compensates the customer by providing a service, rather than by making cash payments to the customer; and
- The insurance risk transferred by the contract arises primarily from the customer’s use of services rather than from uncertainty over the cost of those services.
Recognition
An entity shall recognise a group of insurance contracts it issues from the earliest of the following [IFRS17:25]
- The beginning of the coverage period of the group of contracts;
- The date when the first payment from a policyholder in the group becomes due; and
- For a group of onerous contracts, when the group becomes onerous.
General Measurement Model
The General Measurement model for liabilities under IFRS 17 is known as the building block approach (BBA) and all (re)insurance contracts will be measured as the sum of:
- ‘Fulfilment’ cashflows (updated at each reporting date), which are defined as:
- The present value of probability-weighted expected cashflows (best estimate cashflows), plus
- An explicit risk adjustment for insurance risk
- Contractual service margin (CSM), which is the expected profit from the unearned portion of the contract
Under the BBA, the CSM is amortised and profits are recognised over time as insurance services are provided over the coverage period of the contract (over the term of the policy). However, losses from onerous (or, more simply, ‘loss making’) contracts are recognised immediately. After the end of the coverage period, any future profit or loss from the run-off of the liabilities (which, in general insurance, usually extends past the end of the coverage period), will flow straight through into the income statement.
Opportunity to Simplify
The premium allocation approach (PAA) is a disentangled alternative to the BBA. This simplification is only appropriate in certain circumstances and is only relevant to unexpired risks, but the incurred claims liabilities must still follow the BBA model. Under the PAA approach, the CSM is not required but rather at inception, the liability for unexpired risks, or the “liability for remaining coverage” as it will be known under IFRS 17, is calculated as the premiums received, less associated acquisition costs. Over time, the liability for remaining coverage is updated to reflect additional premiums received (if any), and the profit that has been recognised in the income statement for the coverage that was provided in that period i.e. the premium earned over the period. Again, similarly to the BBA, any losses from onerous contracts must be recognised immediately at inception and, after the end of the coverage period, any future profit or loss from the run-off of the liabilities will flow straight through into the income statement.
This approach will be allowed for contracts where the period of cover is one year or less, or where the measurement of the liability for remaining coverage would not differ materially from that estimated using the BBA. The standard states that the latter requirement is not met if, at inception, there is expected to be significant variability in the fulfilment cashflows affecting the measurement of the liability for remaining coverage during the period before a claim is incurred.
The Variable Fee approach is a variation of the General Measurement Model in which the CSM can be adjusted in response to investment return variations, so investment return variations will not immediately affect profit or loss. This will be applicable to with-profits contracts.
Accounting Policy Options for Risk Adjustment
If using the BBA, for most short-term insurers, the profit from the CSM will be released over a short time period, providing little flexibility. The risk adjustment, however, will run off gradually over the full term, to settlement of all insurance obligations. Therefore, the risk adjustment will be a key driver of the profit profile over time (sometimes referred to as the profit signature). The risk adjustment on gross cashflows is defined as the compensation that an insurer requires to make it indifferent between the present value of uncertain cashflows and the present value of certain cashflows. For ceded cashflows, a risk adjustment must be held to represent the transfer of risk from the insurers to the reinsurer, from the underlying insurance contracts.
The insurer needs to decide on the appropriate policy, methodology and assumptions for setting the risk adjustment. Guidance is provided on factors to consider. These are predominantly focused on appropriately reflecting the risk characteristics of the insurance contracts. However, IFRS 17 does not prescribe an approach, so there is significant flexibility. Accounting policy should be considered carefully, given its impact and how the approach will respond appropriately to changes over time. For example, risk changing over the underwriting cycle.
Challenges
The issues insurers face will vary, depending on the nature of the insurance liabilities, current insurance accounting and existing systems, models and processes. For all insurers, there will also be significant additional disclosure requirements. This includes a new income statement, which will take time to get used to.