Insurance contract reporting under IFRS 17
The development of a new International Financial Reporting Standard for insurance contract accounting (IFRS 17 Insurance Contracts) is approaching completion. The development has been under way for more than 15 years and the long lead time may well be an indication for the significant effort that is expected to implement the standard. The standard, set by the International Accounting Standards Board (IASB), will be applicable to insurance contracts written by entities in the jurisdictions1 that adopt it . The IASB emphasizes the need for a new standard because it is of the opinion that, under current practices, the financial statements are not a true reflection of the nature and extent of the risks embedded in insurance contracts. In addition, the board claims that the proposed standard improves the comparability of financial statements with those of other types of contracts and companies. This article presents the main context and content of the new standard and provides an assessment of the expected impact.
The road to a new balance sheet
In 2001, when the IASB initiated the IFRS 4 project, there was no accounting standard for insurance contracts within the International Accounting Standard (IAS). In the preparation phase of the adoption of the IFRS standards by the European Union in 2005, the IASB released an interim standard (IFRS 4) to be applied until a more comprehensive accounting standard (IFRS 17) could be finalized. This interim standard permits a wide range of accounting practices and includes a ‘temporary exemption’ to a general IFRS ground principle which became effective upon the adoption of the IFRS standards.
Namely, that the entities need to ensure that their accounting policies are relevant to the economic decision-making needs of users of financial statements, and that those accounting policies are reliable. This implied that companies could continue using their existing (and potentially widely varying) accounting models applicable to the insurance products and regulations in their jurisdictions2.
In 2010, the IASB released its first IFRS 17 (back then referred to as IFRS 4 Phase II) exposure draft. The feedback received on this version was incorporated in the second exposure draft, published in 20133. Before the board issues the final IFRS 17 directive by the end of this year, it will amend (among others) the second exposure draft to incorporate transitional measures proposed in 2015 for applying IFRS 9 Financial Instruments4. The board thereby addresses the concerns triggered by the difference between the effective dates of the standards regarding the expected costs and effort for insurers to accommodate two major accounting changes across two different periods impacting both sides of the balance sheet. Namely, if the final IFRS 17 standard is indeed issued in 2017, the standard will become effective no earlier than 2021, while IFRS 9 will come into effect in 2018.
Figure 1 – Implementation timeline of accounting standards
In line with the interim standard, IFRS 17 will apply to all instruments defined by the standard as an insurance contract and thereby applies to any company that has issued them5. According to IFRS 17 a contract that transfers a significant insurance risk to the issuing company, by agreeing to compensate the policy holder for adverse effects of a specified uncertain future event, is an insurance contract. The accounting model for insurance contracts prescribes a number of steps.
Figure 2 – IFRS 17 accounting model procedure
Step 1: Identify and recognize the contract
A contract is recognized at the beginning of the coverage period6 if it complies with the IFRS 17 insurance contract definition. In that case, any embedded derivative components and investment components are separated from the contract and are accounted for in accordance with the relevant accounting standard (e.g. IFRS 9 for derivatives and investments).
Step 2: Measure the contract at initial recognition
Once recognized, the contract will in general be measured by means of the building blocks approach (BBA). However, two alternative models are also defined by the standard: the variable fee approach (for insurance contracts that incorporate participation features7) and the premium allocation approach (for shorter duration contracts or longer-term contracts that meet certain criteria). These alternative approaches form a relief from the more complex BBA. Being the standard model, applicable to the broadest spectrum of insurance contracts, only the BBA will be described here.
Building blocks approach
The BBA aims to incorporate all available information in a way that is consistent with observable market information. It also aims to be more in line with the conceptual accounting framework for other types of contracts (e.g. financial instruments).
Under the BBA, the reporting amount (i.e. carrying amount) of the insurance liability is divided into four blocks as shown in Figure 3.
Figure 3 – Building blocks approach block decomposition
Block 1: Probability weighted estimate of future cash flows
The first block represents the sum of the (non-discounted) probability weighted cash inflows (e.g. premiums) and outflows (e.g. claims, operational costs, and taxes) estimated for the insurance contract at the moment of reporting.
Note that from an accounting perspective, in determining a reporting amount for a liability a cash outflow (inflow) represents a positive (negative) amount. Since for insurance liabilities the non-discounted expected cash outflows tend to be higher than the cash inflow, Figure 3 shows a net cash outflow over the lifetime of the contract.
Block 2: Time value of money – discount curve
The second block represents the discounting of the future cash flows with a market-consistent discount curve that reflects the currency and liquidity of the insurance contract and the timing of its cash flows. The value of block 2 equals the difference between the present value of the probability weighted future cash flows and its non-discounted value (from block 1).
Regarding the example shown in Figure 3, since insurance contracts generally earn premiums at the start of (or during) the coverage period, the discounting causes the net cash outflow to become a ‘negative’ liability present value (i.e. a net gain).
Block 3: Risk adjustment
The third block reflects the entity’s capital required as compensation for the risk of bearing uncertainty about the amount and timing of insurance contracts cash flows, comparable to Solvency II’s risk margin. It is specified on an entity level and thereby considers potential diversification benefits and both favorable and unfavorable outcomes in a way consistent with the entity’s risk aversion. The standard prescribes a number of techniques to calculate the risk adjustment including a confidence level (VaR) approach, conditional tail expectation approach or a cost of capital approach.
Under the latter approach, for example, the risk adjustment for an insurance contract would equal the present value of the costs of capital allocated to the contract taking into account entity-wide assumptions on the capital charge, degree of diversification among risk drivers and confidence level.
As shown in Figure 3, the capital costs for uncertainty lead to an increase in the reporting amount of the liability.
Block 4: Contractual service margin
The fourth block represents the future unearned profits of the insurance contract which are to be recognized in the P/L reporting over the life of the contract. The contractual service margin (CSM) is set at recognition and is determined at portfolio level for contracts with similar inception dates. The CSM is recognized if the sum of blocks 1 to 3 (i.e. ‘fulfillment cash flows’) is negative, such that the reporting amount equals zero which thereby eliminates a ‘Day One Gain’.
After inception, the resulting CSM is periodically ‘released’ in accordance with the insurance coverage provided and reported as revenue in the P/L statement. However, if the contract is part of an onerous8 portfolio for which the aggregate fulfillment cash flows have a positive (liability) value, then the insurance contract is defined as onerous for which no CSM is recognized. Instead, a ‘Day One Loss’ is recognized in the P/L for the portfolio equal to the liability value.
Step 3: Re-measure the contract in subsequent periods
In order to maintain the ‘currency’ of the contract’s value, IFRS 17 stipulates a re-measurement of the insurance contract given all newly available information. Generally, changes in the carrying amount or estimates of the respective blocks are to be recognized in either the P/L or the statement of Other Comprehensive Income (OCI) as shown in the next section.
However, changes in the estimates of future cash flows or the risk adjustment (e.g. due to changing underlying assumptions) are recognized against the CSM by ‘unlocking’ it. If the outcome of the change is favorable9, then the carrying amount of the CSM is increased since the unearned profits increase. If there is an unfavorable outcome, then the CSM is decreased. As such, the changes will have a zero net effect on the total carrying amount of the liability. However, the CSM can only be decreased with the previously reported CSM. Any excess will have to be entered immediately as a loss in the P/L, comparable to the loss of an onerous contract.
Step 4: Present results in financial statements
The presentation of the financial statements firstly includes the reporting of the (re)measured carrying amounts of the insurance contract liabilities on the balance sheet. Secondly, the presentation comprises the reporting of the P/L and OCI statement. The IFRS 17 standard intends to ensure that the presented financial result is consistent for both insurers and entities that do not issue insurance contracts. IASB states this is firstly achieved by recognizing revenues and expenses as earned or incurred, rather than received and paid. Secondly, the standard requires recognition of the unwind of the time value expected over the reporting period10 as an interest expense on insurance liabilities in line with other liability contracts and offsetting the investment income on the assets.
Finally, the changes in the expected (future) time value11 due to changing discount curves are recognized in the OCI statement comparable to the Fair Value Through OCI (FVTOCI) option for debt instruments under IFRS 9. Note, however, that entities may optionally incorporate the effect of changing discount curves on a portfolio in the P/L to align with financial instruments classified as Fair Value Through P/L (FVTPL). The proposal for reporting the financial result incorporating these aspects, is laid down in the ‘earned premium approach’ (EPA).
Earned premium approach
Under the EPA, entries in the statement of total comprehensive income for insurance contracts are made as part of the underwriting result, the investment result and the OCI as shown in Figure 4 and described below.
Figure 4 – Total comprehensive income reporting under EPA
Underwriting result – Insurance contract revenue
For the insurance contract revenue, the EPA applies the general principles of IFRS 15 Revenue from Contracts with Customers. The standard stipulates recognizing revenue when a performance obligation or service has been provided or transferred to the customer, which for insurance contracts implies providing insurance coverage to the policy holder. The insurance contract revenue is thereby allocated to each reporting period in proportion to the reduction of the liability. Note that, as such, the premium income is not captured explicitly as revenue on ‘day one’ given that upon the receipt, the full insurance coverage has not yet been provided. The insurance contract revenue reported in a given period is computed as the sum of the following:
Underwriting result – Insurance contract expenses
The insurance contract expenses comprise both the expenses incurred while providing insurance coverage as well as losses realized on new or existing insurance contracts. The insurance contract expense reported in a given period is calculated as the sum of the following:
Investment result – Interest expenses
Two types of interest expenses on the insurance liability are included in the investment result entry (partly) offsetting the investment income on the assets. The total insurance contract interest expense is computed as the sum of the following:
Other comprehensive income – Discount curve changes
The changes in the time value of money for future cash flows due to changes in the discount curve is presented in the OCI section of the P/L statement. The OCI solution thereby avoids that market interest rate volatility impacts the entity’s profit or loss as the time value will unwind over the life of the contract if held to maturity. The change in the total OCI because of the changes in the discount is determined as the difference between the following:
Note, however, that the total reported OCI as part of equity is the accumulation of the periodic changes in the discount curves. As mentioned earlier entities may also optionally incorporate the effect of changing discount curves on a portfolio in the P/L.
Step 5: Provide disclosures
Under the disclosure requirements, the reporting entity is to disclose qualitative and quantitative information that should enable the users of the financial statements to interpret the nature, amount, timing and uncertainty of the future cash flows of the issued insurance contracts. The disclosures can be subdivided into three broad categories:
Explanation of recognized amounts
The entity is to provide information that enables the user to perform a reconciliation of the amounts disclosed in the profit or loss statement, statement of other comprehensive income and the financial position from the starting to the closing balances.
Significant judgements applied
The entity is to disclose the judgements and changes to the judgements related to the methods used to measure the insurance contracts and the processes for estimating the required inputs. Also the effects of the changes in the methods and inputs producing material impacts on the financial statements should be provided separately.
Nature and extent of risk arising from insurance contracts
The nature and extent of the risks should be disclosed in terms of the exposures, how they arise and how they are managed. Next to insurance risk, it also includes exposures to credit, market and liquidity risk.
The impact of IFRS 17 is expected to be substantial, especially from a data and operational perspective. The (re)measurement of the carrying amounts and the related P/L and OCI reporting requires maintaining a breakdown of the insurance contracts over the building blocks throughout the contract’s lifetime. Additionally, to appropriately account for changes in the carrying amounts, the entity needs to maintain two sets of balance sheet data; one measured at the current discount curve and one at the ‘locked-in’ discount curve. Furthermore, the CSM element is a new concept that does not exist in current accounting standards or Solvency II. Its periodic (re)measurement carries significant practical and operational implications. Next to operational complexities, insurance entities may have to assess how their ALM strategy affects the financial statements under the various new accounting standards. The reclassification of assets under IFRS 9 and changes to P/L and OCI reporting under IFRS 17 might strongly impact the financial results.
On the bright side, certain aspects of the standard may be new from an accounting perspective, but they can be leveraged from Solvency II experience to a certain extent. For example, determining the fulfillment cash flows under IFRS is similar to determining the best estimate liabilities. However, Solvency II employs a holistic balance sheet perspective, whereas IFRS 17 only considers the carrying amount of the insurance liabilities, producing differences in, for example, interpretations of expenses and the scope of contracts. Another example is the discounting of the cash flows, as IFRS 17 is more flexible given that it is governed by principles rather than the rule-based guidance in Solvency II. Finally, in determining IFRS’s risk adjustment, the risk margin of Solvency II can be leveraged.
Click here for an illustrative case study on IFRS 17: IFRS 17 Case Study
1 Upon its finalization, the standard will be proposed to the European Commission which is expected to adopt it.
2 Nevertheless, the disclosure requirements were enhanced and minor changes to provision accounting, adequacy testing and discharging of insurance liabilities were introduced.
3 ‘Exposure Draft Insurance contracts’, ED/2013,7, June 2013, IASB.
4 See the related news item and the overview of all IFRS standards.
5 Note that it also applies to reinsurance contracts that an entity has issued or holds, and investment contracts with discretionary participation features that it issues, provided that the entity also issues insurance contracts.
6 The coverage period is defined as the period during which the entity provides coverage for insured events underlying a certain insurance contract. It includes the coverage relating to all premiums within the boundary of the insurance contract.
7 These include contracts in which the client receives a profit sharing component at the discretion of the issuer based on the P/L of the issuing entity or investment returns of specified pool of assets.
8 An onerous portfolio is defined as a portfolio of contracts in which the economic benefit obtained from fulfilling the underlying agreements is lower than the aggregate costs.
9 Note that for changes in the future cash flows it is determined whether the outcome is favorable by computing the present value of the changes by means of the ‘locked-in’ discount curve, which is the discount curve valid at the moment of recognition of the contract.
10 Note that this value corresponds to the value of Block 2 for the reporting period estimated at the previous reporting moment.
11 Note that these values correspond to the value of Block 2 for the period after the current reporting period estimated at the previous reporting moment and current reporting moment against the discount curves valid at these moments.
12 Note that this is comparable to the release of technical provisions for insurance liabilities.
13 Note that the accreted interest is added to the outstanding balance of the CSM for the next reporting period.