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What’s so tricky about IFRS 17?

Thursday 26 July 2018

Robert Phelps

By Bob Phelps
IASeminars Faculty Member

There have been more than a few eye-catching headliners around about IFRS 17 – “a whole new perspective”, “a game changer”,” a light shining through darkness”, “the dawn of a new era”- all of which, of course, are true.

IFRS 17 is a big new standard for a very big and very old industry. It will change fundamentally the way most insurers report their financial results (for a given period and over time) and financial position. After investing 20 or so years of development effort into IFRS 17, the IASB are highly confident in their expectation that it will bring greater transparency and comparability in financial reporting by insurers.

In particular, the requirement to report the insurance and financial result separately, will result in insurers telling a more complete story about their financial performance, and in so doing provide analysts and others with better information about the overall quality of their earnings.

Having said all that, we will now briefly enter the numerical world of IFRS 17; see what it is all about, and then use this as the context for highlighting some of the trickier areas that will arise in practice.

The IFRS 17 general model

IFRS 17 applies a general accounting model for insurance contracts. To see how different this is compared to existing practice, let us consider the following illustration.

InsCo (which has a 31/12 year-end) issues a group of insurance contracts on 1st January 20X3.

  • Coverage period is 3 years starting 1st January 20X3
  • Premiums are £220 per annum all to be paid on 1st January 20X3
  • Expected claims are £160 per annum

Claims of £20, £90 and £190 were paid in 20X3, 20X4 and 20X5 respectively.

Existing accounting practice will usually spread the premium income over the coverage period with a diminishing unearned premium liability reported in the balance sheet. Claims incurred are expensed in profit or loss, so as to match them with the premium income, faithfully following accountants’ dear old friend the “accruals concept”.

Statement of profit or loss
20X3 20X4 20X5
£ £ £
Revenue
Earned premiums 220 220 220
Expenses
Claims expense (20) (90) (190)
Net profit 200 130 30
Balance sheet liability (X3 to X5)
1/1/X3 B/fwd 0
X3 Cash (660)
P&l revenue 220
31/12/X3 (440)
X4 P&l revenue 220
31/12/X4 (220)
X5 P&l revenue 220
31/12/X5 C/fwd 0

What IFRS 17 does at first instance is to introduce more transparency by identifying and reporting the component parts of the liability (often called its “building blocks”), and how revenue from them is recognised in profit or loss. The gateway to an understanding of these building blocks, is to think for a moment about how (rationally) we could price the InsCo premium. There will be three elements to this:

  1. The net cash outflow - we estimate we will have to pay out £480.
  2. The non-financial risk adjustment – the above £480 is a huge “guesstimate”. Rationally we estimate that we would pay someone £42 to cancel the variability of the cash flow estimate.
  3. The contract service margin - we would like to make £138 profit on this group of contracts.

The premium will therefore be priced £660 (480 + 42 + 138). The “building blocks” on initial recognition of this group of contracts on at 1st January 20X3 will therefore be:

£
Net cash flow [NCF](660 – 480) 180
Non-financial risk adjustment [NFRA] (42)
Contractual service margin [CSM] (138)
Initial liability 0

On 1st January 20X3, these will be recorded in a liability for remaining coverage (LCR) account together with the premiums received.

NCF NFRA CSM Total
£ £ £ £
1/1/X3 - - - -
New contracts 180 (42) (138) -
Cash (660) (660)
LCR c/fwd (480) (42) (138) (660)

Note above how the model breaks the insurance liability out into its component parts. It will now amortise these through profit or loss over the coverage period (on a straight line basis for simplicity’s sake).

Liability for remaining coverage NCF NFRA CSM Total
£ £ £ £
1/1/X3 - - - -
New contracts 180 (42) (138) -
Cash (660) (660)
(480) (42) (138) (660)
X3 – P&L 160 14 46 220
31/12/X3 (320) (28) (92) (440)
X4 – P&L 160 14 46 220
31/12/X4 (160) (14) (46) (220)
X5 – P&L 160 14 46 220
31/12/X5 0 0 0 0
Statement of profit or loss 20X3 20X4 20X5
£ £ £
Insurance revenue
To cover claims 160 160 160
Amortisation of NFRA 14 14 14
Recognition of CSM 46 46 46
220 220 220
Insurance expense
Claims expense 20 90 190
Other expenses - - -
(20) (90) (190)
Insurance result 200 130 30

Using the above as a context setter, let’s now think about potential tricky areas. I have constructed a league table which ranks and briefly explains some of these.

Six tricky areas

No 1 – Fog factor

A major challenge in applying IFRS 17 is to try and translate it into plain language with clear worked examples. The standard and its illustrative examples could be much more helpful in this respect. IFRS 16 on lease accounting does a much better job of this.

No 2 – The time value of money

Insurers will issue contracts with long coverage periods giving rise to very long-term liabilities. Consistent with defined benefit pension liability and long-term loan accounting, the future cash flows must be discounted to present value, and the finance cost (the unwinding of the discount) expensed in profit or loss below the insurance result each year. This is a BIG change for most insurers. What is more, it is a fertile area for trickier issues such as how to identify an appropriate discount rate, and how to account for the impact of changes in it over the coverage period.

No 3 – Estimating the net cash flows

The longer the coverage period, the more of a “guesstimate” this will be. Insurers will have to review their estimation methodology and develop and disclose a quality framework for future cash flow estimation. Furthermore, these must be re-estimated at each year-end and the CSM adjusted. If the changes are very adverse, the CSM could be wiped out, and then provision will have to be made immediately in full for a loss component.

No 4 – Reinsurance

Talking to insurers around the world, an increasing number are expressing concern about how to apply IFRS 17 in this area. Generally, the standard requires the net reinsurance cost to be spread over the coverage period and the cost of claims to be abated by the amount reinsured. The time value of money and cash flow estimation issues will apply here. For proportional reinsurance, the numbers will, for the most part, be a straight % of the amounts pertaining to the insurance contracts issued. However, this will not be the case with non-proportional and excess of loss reinsurance.

No 5 – Some light relief – the premium allocation approach (PAA)

The building blocks approach is a tad heavy-handed for short duration insurance contracts with coverage periods typically of one year or less. IFRS 17 permits the use of the much simplified PAA for these. The resulting numbers are very similar to existing accounting practice, although discounting will be required for such contracts with a financing component.

No 6 - The unit of account

The IFRS 17 rules will be applied to groups of contracts and not individual ones. This involves firstly identifying portfolios of contracts, and then allocating the contracts within each portfolio to time buckets often called cohorts. Insurers must not include contracts issued more than one year apart in the same cohort. The reason for this is to ensure that low margin years are not hidden within good margin years and so lessen the usefulness of trend information. Cohorts will be divided into three groups reflecting the extent to which they are or could become onerous. The accounting rules are applied to each group.

Other problem areas include how to:

√ identify insurance contracts and the unbundling of non-insurance elements;

√ account for contracts with participation features;

√ apply the transitional rules;

√ assemble the data necessary to construct the extensive disclosures required by the standard.

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