In May 2017 the International Accounting Standards Board (IASB) issued IFRS 17 Insurance Contracts. This standard will be applicable for reporting periods starting on or after January 1, 2021.
IFRS 17 represents the most significant change to Sri Lankan insurance accounting requirements, requiring insurers to entirely overhaul their financial statements.
Ernst & Young reports on the summarized requirements of the standard and its possible implications to the insurance industry as follows.
The new requirements are markedly different in a number of critical aspects that will:
- Change profit emergence patterns
- Increase loss recognition
Add complexity to valuation processes, data requirements, assumption setting processes and the requirements for analysing and communicating results
IFRS 17 requires certain components of the insurance contract to be ‘unbundled’ and accounted for separately.
Separation of components
Embedded derivatives in an insurance contract need to be unbundled.
“Distinct” investment components should be separated and accounted for in accordance with IFRS 9. An investment component is ‘distinct’ if a contract with equivalent terms is sold or could be sold separately in the same market or same jurisdiction, either by entities that issue insurance contracts or by other parties. However, it is not considered distinct if the investment and insurance components are highly interrelated.
- Provision of goods and services
Where goods and services are being provided outside of delivering a benefit related to insurance risk, insurers may need to separate these components and account in accordance with IFRS 15.
The standard uses three measurement approaches to account for insurance contracts:
- The General Model (also referred to as the Building Block Approach/BBA) for long-term contracts
- Premium Allocation Approach (PAA) for short-term contracts and
- Variable Fee Approach (VFA) for contracts with direct participation features.
General Model (BBA)
The General Model will be the core measurement model with the insurance contract liability comprising fulfilment cash flows and contractual service margin (CSM). BBA is based on the following ‘building blocks’:
- Estimates of future cash flows
- Adjustment for the time value of money (i.e. discounting) and the financial risks related to the future cash flows
- Risk adjustment for non-financial risks
Fulfilment cash flows include:
The expected, probability-weighted, discounted cash flows within the contract boundary. The objective is to determine the expected value or statistical mean, of the full range of possible scenarios, which will be discounted to present value at a discount rate that reflects the characteristics of those cash flows. However, the proposed discount rate will not be directly observable in the market. As such, it will need to be inferred from other financial instruments applying judgement.
A risk adjustment reflecting the level of compensation the insurer would demand for bearing the uncertainty about the amount and timing of cash flows. The technique used to determine the risk adjustment is not specified but the result will need to be translated into a disclosed confidence level.
Discounting fulfilment cash flows
The standard requires that in determining the fulfilment cash flows, an insurer should discount the estimates of future cash flows to reflect the characteristics of those cash flows.
Contractual Service Margin (CSM)
The CSM is the expected unearned contract profit in an insurance contract. At inception, it will be equal and opposite to the present value of fulfilment cash flows plus pre-coverage cash flows (i.e. acquisition costs). The CSM will be released into profit or loss based on ‘coverage units’ reflecting the amount of coverage provided by contracts in the group, determined by considering the quantity of benefits provided under each contract and its expected duration.
Premium Allocation Approach (PAA)
PAA may be used where:
Contract coverage period (including premiums included in the contract boundary) is one year or less, or
Use of the PAA produces a measurement of the liability for remaining coverage that would not differ materially from that which would be determined based on the General Model.
Variable Fee Approach (VFA)
The VFA is the measurement approach for direct participating contracts that meet three criteria:
The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items;
The entity expects to pay to the policyholder a substantial share of the fair value of returns from the underlying items; and
A substantial proportion of the cash flows that the entity expects to pay to the policyholder are expected to vary with the change in fair value of the underlying.
The VFA assumes that a participating contract creates an obligation for the entity to pay the policyholder an amount equal to the fair value of the underlying items, net of a consideration charged for the contract a “variable fee”. Accordingly, the entity’s interest in the contract would represent a variable fee for the service of managing the underlying items on behalf of a policyholder.
With January 1, 2021 as the effective date, the opening balance sheet for companies with financial year-ends December will be January 1, 2020, which means insurers will have to be substantially done with implementation efforts by that date.
Recognising the challenges that insurers, particularly life insurers, will face in sourcing reliable data to apply a full retrospective approach, a number of transition options have been provided to simplify the approach.
Nonetheless, preparing to apply and transition to the new standard will be an enormous undertaking, affecting many parts of the organisation, particularly finance, tax and actuarial resources.