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This article was first published in the June international edition of Accounting and Business magazine.

The International Accounting Standards Board (IASB) is close to publishing IFRS 17, Insurance Contracts, to replace IFRS 4, Insurance Contracts. It is expected to have an implementation date of 1 January 2021.

IFRS 4 was issued in 2004 as an interim standard that permitted companies to continue their accounting practices. It focused on greater disclosure about the amount, timing and uncertainty of future cashflows from insurance contracts, and was the initial stage in designing an accounting standard for insurance contracts – a second stage was always planned.

Different accounting models have evolved in each jurisdiction according to the circumstances and types of insurance products. This has led to a significant diversity in accounting practices for insurance contracts. These differences have made it difficult for investors and analysts to understand and compare insurers’ results.  

IFRS 17 completes the IASB’s project to make insurance accounting practices consistent across jurisdictions. It offers three major models to apply to all insurance contracts: the general model, the premium allocation approach, and the variable fee approach. As the general model is the default for all insurance contracts, we will examine this in the most detail and give only a brief overview of the other two approaches.

General model

In terms of recognition of items, IFRS 17 introduces two key terms: contractual service margin and fulfilment cashflows.

The contractual service margin is calculated at the start of the contract as the difference between the present value of the expected cashflows (plus a risk adjustment) and the present value of expected premiums. In its simplest form, the contractual service margin represents the overall profit expected on the insurance contract. 

The fulfilment cashflows represent the estimate of the present value of the future cash outflows less the present value of the future cash inflows that will arise as the entity fulfils the contract.

A key principle of IFRS 17 is that no gains are recognised when the contract starts. This is because the entity has not yet satisfied any of its performance obligations. Instead, the contractual service margin is recognised as the entity satisfies the performance obligation, making the treatment consistent with IFRS 15, Revenue from Contracts with Customers. Any unearned profit (such as premiums received) is recognised as a contract liability, being released over the contract period, consistent with the general principles of deferred income. 

If the contract is deemed loss-making at inception, the loss is recognised in full immediately as an onerous contract, consistent with IAS 37, Provisions, Contingent Liabilities and Contingent Assets.

As for grouping contracts, entities will continue to assign contracts to portfolios with similar risks and managed together in a single pool, such as whole life insurance or car insurance. Each portfolio must be divided into groups for contracts issued in the same 12-month period, as follows:

  • Contracts that are onerous at inception: will require an immediate loss to be recognised in profit or loss
  • Contracts that at inception have no significant possibility of becoming onerous subsequently: will require any unearned profit to be recognised as a liability and released as the insurance is provided
  • Other profitable contracts: will require recording in the same way as contracts deemed to have no significant possibility of becoming onerous.

A narrow exemption here is where an entity is constrained by law or regulation to set prices or benefit levels that vary according to policy characteristics. This followed lobbying by insurers operating in the EU, who must charge men and women the same for the same insurance products without distinction on grounds of gender. If this exemption applies, the entity may include these contracts in the same group and disclose the fact that it has been applied.

Dealing with changes

In terms of discount rates, insurance contracts will be measured at current value, using discount rates that reflect the characteristics of the insurance cashflows. The use of current interest rates will be a change for companies that currently use the expected return on assets held as the discount rate.

As the discount rates used are updated regularly to show the current interest rates, any changes to the liability arising from a change in the discount rate used should be shown in other comprehensive income, rather than profit or loss.

Any increases in the liability arising from the time value of money based on the discount rates used will still be shown in profit or loss, following the ‘unwinding the discount’ principle prevalent in many existing IFRSs.

As for the contractual service margin, in addition to the changes made to reflect discount rates and the time value of money, the present values of the fulfilment cashflows must be updated each year to reflect the anticipated cashflows. This has been a point of debate, but the tentative conclusions drawn by the IASB are:

  • Changes in estimates of the present value of future cashflows arising from non-financial risks (other than those relating to incurred claims), are adjusted against the contractual service margin, so these changes will effectively be spread over the remaining contract period as the service margin is recognised.
  • Changes relating to incurred claims should be recognised in profit or loss for the period, rather than in the contractual service margin. This will result in the full impact of the changes being recognised in the current period rather than being spread over the remainder of the contract.

Alternative approaches

This premium allocation approach can be used where the coverage period is less than a year, or where there are no significant expected changes in estimates before the claims are incurred.

The calculations are similar to those under the general model, but there is no requirement to discount the liability to reflect the time value of money. There are also fewer disclosures required. 

The premium allocation approach has been introduced to cut IFRS 17 implementation costs for simpler contracts, such as short-term non-life insurance. 

The variable fee approach can be used only for contracts with direct participation features, as outlined in the following situations: 

  • The policyholder participates in a share of a clearly identified pool of underlying assets
  • The entity expects to pay a substantial share of the return from those underlying assets to the policyholders
  • Cashflows are expected to vary with underlying assets.

Under the variable fee approach, the fulfilment cashflows that are expected to vary directly with return on the underlying items are presented in accordance with the treatment of the underlying item. 

Accordingly, if the underlying item is a financial instrument held at fair value through other comprehensive income, the changes in the fulfilment cashflows that vary directly with these returns are also taken to other comprehensive income. Likewise, if the underlying pool of assets is held at fair value through profit or loss or at amortised cost, the changes would be taken through profit or loss.

Disclosure changes

Many of the disclosures for IFRS 4 are kept in IFRS 17, along with an outline of the risk adjustment applied and the contractual service margin. The general model requires disclosure and reconciliation of the expected present value of future cashflows, risk adjustment and contractual service margin. No such disclosure is required under the variable fee approach. 

The application of IFRS 17 is likely to be complex, requiring the input of many specialists, and many entities will need to make significant changes to their accounting policies. The hope is that this first full attempt at a global standard for insurance contracts will help eliminate the myriad of different accounting policies in use. 

Adam Deller is a financial reporting specialist and lecturer