2. The new standard will replace interim standard IFRS 4: Phase I for entities to continue with their current diverse practices of reporting insurance contracts.
KEY CHANGES
1. Under the new IFRS standards, unbundling of contracts is allowed only if it is required. Any voluntary unbundling under the current IFRS must be removed on transition to IFRS 17 and contracts accounted for under the new standard.
3. Liability measurement has an allowance for risk adjustment (RA) for risks and uncertainty. Such as economic risks from embedded options and unhedgeable insurance risks.
4. Insurers report earnings reflecting services provided and not cash received. A contractual service margin (CSM) to control release profits in line with services.
INVESTMENT LINKED CONTRACTS
1. Variable fee approach would be use to deal with participating business where policyholder liability is linked to underlying items.
2. Contracts with a direct link to underlying investment performance need to be split into either cash flows that vary directly with the investment or fixed payments/ other embedded options.
3. Changes in the cash flows that are expected to vary directly with asset returns are recognised on the same basis as the change in value of the assets.
4. Changes in cash flows are not expected to vary directly with asset returns are valued using the building block approach (BBA).
BUILDING BLOCK APPROACH FEATURES
1. Discounted cash flow model with allowance for risk. It uses a market consistent risk-free discount rate with an allowance for an illiquidity premium. Discount rates reflect characteristics of the insurance contracts.
2. It is based on best estimate projected cash flows. No day one profits – recognised as a CSM and amortised in P&L over contract term (straight line basis)
3. New income statement presentation and definition of revenue. Other Comprehensive Income (OCI) option for changes in discount rates to reduce P&L volatility.
4. Transition approach allows significant simplifications and judgement. Higher transparent disclosures, Market-consistent valuation of options and guarantees
5. It includes a RA to reflect all risks other than those reflected through the use of market consistent inputs.
6. For short term contracts with little variability, Premium Allocation Approach (PAA) will be used to measure the pre-claims liability – akin to unearned premium accounting. This simplified model is allowed for short duration contracts (coverage period up to one year) or reasonable approximation of BBA. Under the BBA, the reporting amount (i.e. carrying amount) of the insurance liability is divided into four blocks as shown below
7. Block 1: Probability weighted estimate of future cash flows - 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.
8. Block 2: Time value of money (discount curve) - 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.
Note: The value of block 2 = the difference between the present value of the probability weighted future cash flows and its non-discounted value from block 1.
9. 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. 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.
Note: Under cost of capital approach, 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.
10. Block 4: Contractual service margin - 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 CSM is set at recognition and is determined at portfolio level for contracts with similar inception dates.
Note 1: The CSM is recognized if the sum of blocks 1 to 3 is negative, 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.
Note 2: If the contract is part of an onerous portfolio with positive (liability) value, no CSM is recognized. A ‘Day One Loss’ is recognised in the P/L for the portfolio equal to the liability value.
CONTRACTUAL SERVICE MARGIN
1.Represents unearned profits in contracts, CSM means that all day one profits from contracts are eliminated, with profits instead being released systematically over the lifetime of the contracts on a basis consistent with customers benefiting from the underlying insurance risk.
2. Insurers are required to calculate and monitor the CSM. Contracts need to be grouped into portfolios, with a portfolio being defined as a group of contracts within a single product line with similar risks. Each portfolio then needs to be split into a group of onerous contracts and those expected to generate a profit.
3. firms can’t group contracts issued more than one year apart - insurers will need to maintain records of annual cohorts of portfolios.
DIFFERENCES WITH SOLVENCY II
1. Different best estimate cash flows may result from the level of aggregation of policies when projecting cash flows, the assignment of expenses, and differing contract boundaries.
2. Under IFRS 17 insurers can derive their discount rate from a ‘top-down’ approach starting with a discount rate from a reference asset portfolio and making allowance for defaults and mismatching. Or, a ‘bottom-up’ approach starting from a ‘risk-free’ rate and adding in an illiquidity premium based on the projected liability cash flows.
3. Solvency II uses different discount rates espeacially for firms using matching adjustments driven by risk-adjusted yields on assets actually held.
4. The IFRS 17 principles for calculating the risk adjustment (RA) are much less prescriptive than those for calculating the Solvency II risk margin (RM).
5. IFRS 17 requires firms to allocate the RA at a more granular level than the RM which may translate to significantly different results.
THOUGHTS
1. There will be impacts on data requirements, administration and reporting systems, and valuation processes, including methodologies and assumptions.
2. It will result in fundamental changes for liabilities and earning calculation. Earnings from profitable insurance contracts presented as services are provided ensures that earnings are recognized more consistent with smoother patterns. Existing practices recognize profit in advance.
3. IFRS 17 is likely to provide a number of policy choices and options such as OCI to manage profit and loss volatility and the use of the PAA for short duration business. tax position will be taken account in choosing the preferred policy or option.
4. Decisions made around the CSM at transition are likely to impact profit emergence over many subsequent years.
5. We will look at implications and impact in detail in upcoming posts.
(Source: Hymans, PWC, zanders)
