New kid on the block - IFRS 17: An overview
ME PoV Spring 2020 issue
IFRS 17, the latest standard issued by the International Accounting Standards Board (IASB), establishes principles for the recognition, measurement, presentation and disclosures of insurance and reinsurance contracts issued and held by entities. The standard, similar to IFRS 4, focuses on types of contracts rather than types of entities and hence, generally applies to all entities that write insurance contracts. The standard is expected to be effective 1 Jan, 2022. Considering that we still have two years to comply, why discuss this now? The reason lies in the complexity of the standard itself, not only with respect to its application, but also in relation to its interpretation.
IFRS 17 will supersede IFRS 4, which is the current financial reporting standard under which insurance companies prepare their financial statements. This article discusses how IFRS 17 differs from IFRS 4, and provides an overview of the standard and its application.
IFRS 17 applies to the following contracts:
- Insurance contracts issued by an entity,
- Reinsurance contracts issued by an entity,
- Part of the insurance contracts that a company has ceded (sold/transferred risk) to the reinsurance company (reinsurance contracts held by an entity),
- Investment contracts with discretionary participation features, provided the entity also issues insurance contracts (discretionary because the benefit to the policy holder is discretionary and market-related).
IFRS 17 vs. IFRS 4
The key difference between IFRS 17 and IFRS 4 is the consistency of application of accounting treatments to areas such as revenue recognition and liability valuation. Under IFRS 4, entities were free to derive their own interpretations of revenue recognition and calculation of reserves. For example, it was at the discretion of the companies to include risk adjustment in the liabilities under IFRS 4, whereas it is now mandatory under IFRS 17. The table below provides more detail around the fundamental differences between IFRS 4 and IFRS 17.
IFRS 17 – Key requirements
Entities often have products that have insurance and non-insurance components. IFRS 17 advises that the non-insurance component of the contract should be segregated from the overall contract, and treated under the relevant accounting standards if such non-insurance component is distinct. This process of separating the non-insurance component from the insurance contract is called unbundling.
Under IFRS 4, companies were able to use their discretion with respect to determining unbundling, while under IFRS 17 there are strict criteria that should be met before unbundling can be done.
In the case that unbundling is required, companies need to segregate the non-insurance component and account for it under a separate accounting standard such as IFRS 9 or IFRS 15. Investment-related components will generally go under IFRS 9, while any component that pertains to goods or services will fall under IFRS 15.
Under IFRS 17, insurers need to assess if a policy holder can benefit from a particular service as part of a claim or irrespective of the claim/risk event. In case a service may only be benefited from when an insured event occurs—such as an accident in the case of motor insurance— then that service does not need to be unbundled. However, if a service such as road-side assistance, can be availed of by the policy holder irrespective of a claim event, then the insurer might be required to unbundle that component and account for it under IFRS 15, and not under IFRS 17.
Level of aggregation
Under IFRS 17, the entities will need to identify portfolios of insurance contracts at initial recognition and divide them into a minimum of the following groups:
- Contracts that are onerous at inception;
- Contracts that have no significant possibility of becoming onerous subsequently; and
- Remaining contracts in the portfolio.
Losses on onerous groups of contracts are immediately recognized in the profit or loss account.
An entity cannot include contracts issued more than one year apart in the same group. Therefore, each portfolio will be disaggregated into cohorts consisting of periods of one year or less.
IFRS 17 provides three measurement approaches for the accounting of insurance contracts. These include the General Measurement Model—or Building Block Approach (BBA), the Premium Allocation Approach (PAA or simplified approach) and the Variable Fee Approach (VFA). The three models lay down the approach to be followed for calculating the components of the insurance contract liability, namely the liability for incurred claims (LIC), and the liability for remaining coverage (LRC), as appropriate.” LIC refers to the claims already lodged, or about to the lodged, for a particular policy, such as an accident in the case of a motor policy. LRC refers to the company’s expectation of future claims on a particular policy. The company is required to create liability for both LIC and LRC.
General Measurement Model (GMM)
The General Measurement Model is defined as follows: at initial recognition an entity shall measure a group of contracts as the total of (a) the amount of fulfilment cash flows (FCF)—which comprise estimates of future cash flows, an adjustment to reflect the time value of money (TVM) and the financial risks associated with those future cash flows, and a Risk Adjustment (RA) for non financial risk—and (b) the contractual service margin (CSM). The discounted estimates of future cash flows along with the RA will provide the fulfilment cash flows to be created for the insurance contract. The CSM will provide the unearned income to be recorded for the insurance contract and forms part of the liability for the remaining coverage.
At every subsequent reporting date the entity will recalculate the FCFs and CSM in similar fashion as described above.
Premium Allocation Approach
An entity may simplify the measurement of the liability for remaining coverage of a group of insurance contracts using the Premium Allocation Approach (PAA) instead of the General Measurement Model on the condition that the measurement of the liability would not be materially different from the measurement of the liability under the GMM, or the coverage period of insurance contracts in the group is one year, or less.
The key simplification in the PAA approach is the exemption granted from calculating and explicitly accounting for the CSM. PAA is not applicable for the Liability for Incurred Claims for which the GMM (or BBA) will apply.
Variable Fee Approach
The Variable Fee Approach (VFA) can be used for contracts where cash flows are market-dependent, such as investment returns. The variable fee equals the company’s share of the fair value of the underlying items, or investments, less the fulfilment cash flows that do not vary with the underlying items. VFA is used for contracts with the following characteristics:
- The policy holder participates in a share of a clearly identified pool of underlying items or investments;
- The company expects to pay the policy holder an amount equal to a substantial share of the fair value returns on the underlying items; and
- The company expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in the fair value of the underlying items.
IFRS 17 brings with it a lot of challenges and opportunities for insurance companies. Some of these key challenges, and how to manage them, include:
High operational costs
A fragmented and complex IT infrastructure legacy
Human resource capabilities
Readiness of Board of Directors (BoD)
Ownership to implement change
by Elias Ma’ayeh, Partner, and Zeeshan Abbasi, Senior Manager, Risk Advisory, Deloitte Middle East