What Accounting Considerations Must Be Taken Into Account for IFRS 17 Insurance Contract Liabilities

IFRS 17 Overview

IFRS 17 is the International Financial Reporting Standard that specifies the accounting for insurance contracts. This standard was issued to provide a consistent, principle-based framework for the insurance industry. It represents a significant change from its predecessor, IFRS 4, which was merely an interim standard allowing a wide range of accounting practices.

The implementation of IFRS 17 aims to enhance comparability and transparency in the financial statements of insurance companies. It requires that insurance contracts be accounted for in a manner that reflects the timing of cash flows and the uncertainty inherent in the obligations from insurance contracts.

Under IFRS 17, insurance liabilities must be recognized and measured at a current fulfillment value that anticipates future cash flows. Here is a breakdown of key components:

Liability for Remaining Coverage (LRC): Represents the obligation before services are provided.
Liability for Incurred Claims (LIC): Represents the obligation for claims related to past services.

Financial statements will present the effect of changes in these estimates, ensuring that they represent up-to-date information about the obligations and risks related to insurance contracts.

The standard specifies a measurement model known as the General Model, applicable to most contracts, which is a modified version termed as the Premium Allocation Approach suitable for simpler contracts.

Implementation of IFRS 17 began after its effective date, January 1, 2023, providing a more detailed reflection of how companies earn profits and incur expenses through their insurance contracts. This transition to the new IFRS standards impacts operational and system changes, impacting the entire insurance industry.

Scope of Insurance Contracts under IFRS 17

IFRS 17 specifies how an entity should recognize, measure, present, and disclose insurance contracts. This standard requires entities to identify contracts that fall within its scope accurately.

Definition of an Insurance Contract

Under IFRS 17, an insurance contract is specifically defined as a contract in which one party (the issuer) accepts significant insurance risk from another party (the policyholder), by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder. The following elements must be present for a contract to be considered an insurance contract under IFRS 17:

Significant insurance risk transfer: There must be a possibility for the insurer to pay significant additional benefits in any scenario for it qualifies as an insurance contract.
Specified uncertain future event: The event covered by the insurance contract must be uncertain in terms of occurrence, timing, or amount.
Compensation to the policyholder: Upon the occurrence of the insured event, there must be a valid requirement for the issuer to compensate the policyholder.

Distinguishing Insurance Contracts from Other Contracts

Entities must distinguish insurance contracts from other types of contracts by examining the substance of the contractual rights and obligations. Contracts that do not transfer significant insurance risk, but may instead transfer financial risk, are typically classified as financial instruments rather than insurance contracts. For example:

Financial Instrument vs. Insurance Contract: If the primary purpose of the contract is to provide financial benefits without significant insurance risk, it is a financial instrument, not an insurance contract.
Investment Contracts: Investment contracts, which may include discretionary participation features, are often considered distinct from insurance contracts because they principally involve financial rather than insurance risk.
Discretionary Participation Features (DPFs): These features, which are sometimes found in insurance or investment contracts, provide the contract holder with additional rights to participate in the returns of a pool of underlying items. Contracts with DPF are evaluated to determine whether the significant insurance risk is present, without it, they don’t fall under the scope of IFRS 17.

Entities must carefully analyze the characteristics of their product offerings to distinguish those that meet the definition of an insurance contract and thus fall within the scope of IFRS 17.

Recognition of Insurance Contracts

When recognizing insurance contracts under IFRS 17, insurers must consider the contract’s initial recognition and precise measurement. These elements ensure the accurate representation of insurance contracts’ liabilities on financial statements.

Initial Recognition

Insurance contracts under IFRS 17 are recognized when the entity becomes a party to the contract and has a legal obligation to provide insurance coverage. This moment marks the entity’s obligation to measure the contract according to IFRS 17 requirements.

Measurement of Contracts at Initial Recognition

At initial recognition, an insurance contract is measured on the basis of the expected fulfillment cash flows and a Risk Adjustment for Non-Financial Risk. The measurement involves three components:

Discounted Cash Flows (DCF): Estimates of future cash inflows and outflows must account for the time value of money and the financial risks associated with the future cash flows.
Risk Adjustment: An amount that reflects the compensation the insurer requires for bearing the uncertainty inherent in the cash flows.
Contractual Service Margin (CSM): Represents the unearned profit of the contract that will be recognized as income over the coverage period.

The measurement of insurance contracts at initial recognition is not static and will need to be recalibrated in case of any changes in the assumptions that underpin the cash flow estimates.

Measurement Models

Under IFRS 17, there are two primary measurement models prescribed for recognizing insurance contract liabilities: the General Measurement Model (GMM) and the Premium Allocation Approach (PAA). Each approach has distinct criteria that an entity must consider and apply based on the nature and complexity of the insurance contracts it issues.

General Measurement Model (GMM)

The General Measurement Model, commonly identified as GMM, is a comprehensive framework designed for insurance contracts that require thorough and detailed valuation. Under GMM, insurance liabilities are measured on a current value basis, considering both future cash flows and the timing and uncertainty of those cash flows. This model incorporates a range of factors including:

Estimates of future cash flows: These are projections of payments for claims and benefits, as well as premiums to be received.
Adjustment for the time value of money: Discount rates are applied to estimate the present value of the expected future cash flows.
A risk adjustment for non-financial risk: This reflects the compensation that the insurer would require for bearing the uncertainty associated with the cash flows.

Premium Allocation Approach (PAA)

The PAA is a simplified measurement alternative to the GMM, and it can be used if it would produce measurements similar to those produced by the GMM or if the coverage period of the contract is one year or less. The PAA is suitable for less complex contracts or those with a shorter duration. It involves:

Unearned Premium Assessment: Liabilities are assessed on the premiums received, which are not yet earned.
Simplification of Liability Measurement: Instead of a full estimation of future cash flows, the PAA relies on the allocation of the premium over the coverage period, utilizing simplified cash flow projections and an implicit inclusion of a risk adjustment.

In the PAA, the recognition of insurance revenues corresponds with the coverage period, and the expenses are recognized when incurred, simplifying the accounting process in comparison to the GMM. The entity’s decision to adopt PAA hinges on its contracts either having a coverage period of not more than one year or fulfilling the PAA criteria where the results are expected to approximate those of GMM.

Estimating Future Cash Flows

Under IFRS 17, the estimation of future cash flows is a fundamental aspect of recognizing insurance contract liabilities. The standard requires a systematic and consistent approach to predict and account for the cash flows over the duration of the insurance contract. These cash flows must consider all contractual benefits and related fulfillment cash flows, including claims, premiums, and expenses.

Assumptions employed in these estimations must be realistic and based on the best available information. Actuarial models often play a significant role in this, drawing on historical data and expert judgment to forecast future outcomes. The assumptions must account for various uncertain future events that could impact the occurrence and timing of cash flows.

Discounting: The insurance contract’s future cash flows are discounted to their present value, considering the time value of money and financial risks.
Risk Adjustment: Providers must include a risk adjustment for non-financial risk, reflecting the degree of uncertainty in the amount and timing of the cash flows.

Estimates of future cash flows should not include:

Inflows or outflows that may arise from future restructuring;
Cash flows from improving or enhancing the asset’s performance;
Financing activities or income tax receipts/payments.

Estimations need to be updated regularly to reflect changes in market conditions, models, and data. An actuarial approach that thoroughly evaluates present and future scenarios ensures that the obligations under the contract are adequately covered by the recognized liabilities.

Adjustments for the Time Value of Money

The recognition of insurance contract liabilities under IFRS 17 necessitates accounting for the time value of money, as it significantly affects the measurement of insurance contracts. The standard requires that the liability for insurance contracts includes a discount to reflect the time value of money and the financial risks associated with it.

Determining Discount Rates

Under IFRS 17, the discount rates used to measure the insurance contract liabilities should reflect the characteristics of the insurance contract’s cash flows. These rates need to be consistent with observable market prices for financial instruments with similar characteristics, such as timing, currency, and liquidity. Insurers must ensure that the discount rates employed do not include risks that are not relevant to the insurance contract liabilities or include non-financial risks, avoiding double counting. A portfolio-specific approach may be taken when market rates are not directly observable, using a technique that maximizes the use of relevant observable market data.

Present Value of Future Cash Flows

Calculating the present value of future cash flows is a critical component of recognizing insurance contract liabilities. Discounting future cash flows requires projection based on estimates grounded in historical data and forward-looking assumptions. Insurers must contemplate the timing, amount, and uncertainty of cash flows, and adjust for the time value of money over the duration of the insurance contracts. This involves a probability-weighted estimation of cash flows, considering both policyholder obligations and expected premiums, and adjusting these estimates to reflect the present value through discounting.

Risk Adjustment for Non-financial Risk

Insurance risk inherently involves uncertainties that affect the timing and amount of cash flows. Under IFRS 17, insurers are required to account for these uncertainties through a risk adjustment for non-financial risk. This adjustment is intended to reflect the compensation insurers need for bearing the uncertainty related to non-financial risks.

Financial vs. Non-financial Risk: Non-financial risks are those not related to financial instruments and can include underwriting risk or claims risk.
Measurement: The measurement of this adjustment is not specified by IFRS 17, allowing insurers the flexibility to select an appropriate method that best reflects the nature of the risk.

The compensation is quantified by considering the likelihood of an uncertain future event impacting the liability cash flows. Insurers must disclose both their chosen method for calculating the risk adjustment and the confidence level upon which it is based. For instance:

Confidence Level: e.g., a 75% confidence level implies that there is a 75% likelihood that the insurance contract liabilities will not exceed the estimated amount, including the risk adjustment.

The chosen approach must be able to ascertain the risk adjustment reliably:

Coherence: Must be consistent with the characteristics of the non-financial risk.
Disclosure: Insurers must provide sufficient information for users of financial statements to understand the amount, timing, and uncertainty of future cash flows.

It is worth noting that as experience unfolds and uncertainties reduce, the risk adjustments can decrease correspondingly, affecting the reported insurance contract liabilities.

Contractual Service Margin (CSM)

The Contractual Service Margin, or CSM, is a crucial component in the recognition and measurement of insurance contract liabilities. It embodies the unearned profit of insurance contracts that is recognized over the coverage period, providing a measure for revenue allocation.

Recognition of Profit Over the Coverage Period

Under IFRS 17, insurance companies recognize the profit from insurance contracts over the period in which coverage is provided. The CSM represents the expected profit from these contracts and is released into income systematically. Profitable contracts are those for which the CSM is positive, indicating that the expected future cash flows exceed the present value of the fulfilled obligations.

Release of CSM: Profit is recognized in the income statement as the insurer provides services and as the CSM is released.
Adjustment Mechanism: Changes in estimates related to future service periods will adjust the CSM to ensure that profit recognition reflects the latest expectations.

Loss-making Contracts and CSM

For loss-making contracts, where the expected cash outflows exceed the inflows, the standard requires immediate recognition of a loss. The CSM is adjusted accordingly:

No CSM is created: If the contract is loss-making at inception, a full loss is recognized immediately, and no CSM is established.
Adjustments for onerous contracts: Contracts that become loss-making subsequent to their initial recognition will have their CSM reduced. If the CSM is not sufficient to absorb the losses, the excess is recognized in the profit and loss immediately.

Entities must carefully assess their portfolio of insurance contracts, routinely evaluating the profitability to manage and reflect the CSM accurately for both profitable and loss-making contracts.

Presentation in Financial Statements

When recognizing insurance contract liabilities under IFRS 17, entities must present these items clearly in their financial statements. Specifics of both the insurance contract liabilities and the revenue and expense recognition are pivotal for understanding the performance of an insurance entity.

Insurance Contract Liabilities

Insurance contract liabilities represent obligations that an insurance company has assumed in exchange for the insurance premiums it has received. Under IFRS 17, they must be presented on the Statement of Financial Position. The standard requires that these liabilities be measured on an updated and forward-looking basis, which includes current estimates of future cash flows, discount rates, and risk adjustment. Liability adequacy is tested at each reporting date, ensuring that the recognized insurance liabilities are sufficient to cover anticipated insurance service payouts.

The insurance service results, reflected in the financial statements, include the presentation of:

Insurance contract liabilities carried at the current balance sheet date.
Movements in these liabilities due to insurance service provided during the period.

The presentation should make clear the connection between the insurance contract liabilities and any related insurance finance income or expenses, deconstructing the financial performance of the entity.

Revenue and Expense Recognition

The timing of recognition of revenues and expenses under IFRS 17 aligns with the provision of insurance services. Revenue recognition is based on the concept of the insurance service provided in the period, called coverage units. This approach sees entities recognizing revenue over the period in which the coverage is provided, reflecting the insurance service results for the period.

The finance income or expenses related to the insurance contract liabilities, which include the effect of the discount rate and changes in it, are presented separately in the statement of financial performance. IFRS 17 requires that entities disclose:

The total insurance revenue recognized in the period.
The insurance service expenses incurred.
The insurance finance income or expenses.

This separation enhances the transparency regarding the entity’s performance, showing how insurance finance income or expenses influence the profitability independently from the insurance service results.

Disclosures and Reporting

In compliance with IFRS 17, insurance companies are required to provide detailed disclosures that enable financial statement users to assess the effect insurance contracts have on the entity’s financial position, financial performance, and cash flows.

Quantitative and Qualitative Information

Quantitative disclosures require insurance companies to prepare numerical information about the risks arising from insurance contracts. These disclosures must include:

The reconciliation from opening to closing balances of the net carrying amount of insurance contract liabilities.
Amount, timing, and uncertainty of future cash flows from insurance contracts.

Qualitative disclosures focus on the nature and extent of risks arising from insurance contracts, including:

Explanations of defined terms, risk exposure, and how they arise.
The entity’s objectives, policies, and processes for managing risks.

Reporting on Financial Performance

Reporting on financial performance involves the provision of information that reflects the insurance company’s financial strength and performance during the reporting period. Entities must disclose:

The total insurance revenue recognized in the period from the group of insurance contracts.
The effect of contracts initially recognized in the reporting period.
Analysis of insurance revenue recognized from groups of insurance contracts issued in different annual reporting periods.

These disclosures provide critical insights into an insurance company’s revenue patterns and facilitate a better understanding of financial performance across different periods.

Transition to IFRS 17

The transition to IFRS 17 marks a significant shift from IFRS 4 to a new, consistent accounting framework for insurance contracts. Entities must carefully consider the new standards to ensure an effective transition and proper recognition of insurance contract liabilities.

Comparative Information

Under IFRS 17, entities are required to present comparative information that provides insight into the financial impact of the new insurance contract standard. This information must be restated as if IFRS 17 had always been applied, allowing users of financial statements to understand the timeline and magnitude of changes. There are, however, transitional provisions in place to help entities adapt to the new requirements without undue cost or effort.

Transition Approaches

Entities have the option to choose between different transition approaches when first applying IFRS 17, which cater to varying degrees of availability of historical data. The approaches are as follows:

Full Retrospective Approach (FRA): Applied as if IFRS 17 has always been in effect, provided the entity can reasonably and consistently determine the historical information.
Modified Retrospective Approach (MRA): Used when an entity cannot apply FRA but can still obtain enough historical information to achieve the principle’s objective without full retrospectivity.
Fair Value Approach (FVA): When it is impracticable to apply FRA or MRA, entities use the fair value of insurance contracts at the transition date as a deemed cost to determine the contractual service margin (CSM) going forward.

The choice of transition approach influences the comparability and understandability of financial statements across periods, and entities must disclose the approach taken.

Entities must consider the complexity of transitioning to IFRS 17 and the effects on financial reporting. The decisions made during the transition will have long-term implications for how insurance contracts are reported and understood by stakeholders.

Operational Considerations

When implementing IFRS 17 for insurance contract liabilities, insurers must meticulously address operational challenges. These challenges encompass adapting existing systems and establishing robust data management protocols.

Systems and Processes

Insurance companies are required to ensure that their systems and processes are sufficiently robust to support the complex requirements of IFRS 17. This involves:

Upgrading or replacing legacy systems that may not handle the intricacies of IFRS 17, especially where cash flows are concerned.
Implementing processes that support the recognition and measurement of insurance contracts, including the Contractual Service Margin (CSM).
Ensuring systems interoperability to facilitate seamless data flow and accurate financial reporting.
Integrating interdepartmental communication to align actuarial and accounting functions, minimizing the risk of discrepancies.

Data Management and Analysis

Under IFRS 17, data management and analysis become critical due to the granularity and fidelity of data required. Insurers must address:

The establishment of a centralized data repository that ensures data quality and availability.
Implementation of analytical tools capable of handling the volume and complexity of data IFRS 17 requires, allowing for meticulous assessment of insurance contract liabilities.
Development of control mechanisms to maintain data integrity and reconcile data from different sources to support accurate liability measurement.
Ensuring their account and financial reporting practices are supported by accurate, high-quality data inputs from all relevant departments within the organization.

Tax Implications

Under IFRS 17, insurance companies are required to consider new accounting models for revenue recognition and the measurement of insurance contracts. These changes bring about several tax implications that must be incorporated into the financial position reporting of an insurer.

Impact on Deferred Tax Assets and Liabilities

IFRS 17 introduces the Contractual Service Margin (CSM), which affects insurers’ profit recognition patterns.
The change in timing of profit recognition could lead to a shift in the recognition of deferred tax assets and liabilities.
Insurers must re-evaluate their tax position, considering the possibility of more volatile tax expense recognition in their profit or loss statements.

Operational Model Adjustments

IFRS 17 requires insurers to integrate tax impacts at each stage of their reporting process.
Adjustments may involve policies, procedures, personnel, and data and systems.
These operational modifications aim at ensuring consistent tax calculations and disclosures.

Specific Tax Cash Flows

Transaction-based taxes such as premium taxes, value added taxes, and goods and services taxes must be linked directly to the fulfillment of the insurance contract.
IFRS 17 mandates the inclusion of these taxes in the cash flows used to measure the insurance contract liabilities.

Additional Considerations for Insurers

Insurers should assess the impact of IFRS 17 on their balance sheets and recognize any change in their tax liabilities accordingly.
The standard may alter how certain items are classified for tax purposes, requiring re-examination of existing tax strategies and planning.

In essence, the transition to IFRS 17 necessitates a comprehensive analysis of tax implications for insurers, implying a need for a holistic approach to tax accounting within the context of insurance contract liabilities.

Comparisons with Other Frameworks

When examining the accounting considerations for recognizing insurance contract liabilities under IFRS 17, it is important to understand how this standard differs from its predecessor IFRS 4 and the corresponding U.S. Generally Accepted Accounting Principles (US GAAP).

IFRS 17 vs Previous IFRS 4

IFRS 17 introduces a new measurement model for insurance contracts, significantly diverging from the principles of IFRS 4. IFRS 4 allowed insurers to use a wide range of accounting practices for insurance contracts, leading to inconsistencies in reporting. IFRS 17, however, mandates a consistent approach by proposing a General Measurement Model,also known as the Building Block Approach (BBA). This model incorporates:

Current valuation of future cash flows
Risk adjustment for non-financial risk
Contractual Service Margin (CSM) representing the unearned profit of the contract

The introduction of CSM under IFRS 17 marks a distinct shift from IFRS 4, ensuring that the profit from insurance contracts is recognized over the period services are provided, and not upfront.

IFRS 17 vs US GAAP

The differences between IFRS 17 and US GAAP are multiple and substantial. While IFRS 17 applies a single, principle-based approach to insurance contract accounting, US GAAP entails various topic-specific guidelines that can lead to different accounting treatment for similar transactions. While IFRS 17 utilizes the BBA for all insurance contracts, US GAAP has separate models for long-duration contracts and short-duration contracts.

One notable point of contrast lies in the liability recognition, where IFRS 17 requires current assumptions to be updated at each reporting date, which could reflect in more volatile financial statements. In contrast, under US GAAP, the assumptions are typically locked in at contract inception and only updated if loss recognition testing indicates that the original assumptions need revision.

For accounting periods, IFRS 17’s effective date was January 1, 2021. However, entities have since worked on the implementation, with comparative periods needing restatement. Meanwhile, US GAAP is not expected to converge with IFRS 17, as differences in fundamental principles like the aforementioned persist, leading to distinct recognition, measurement, and disclosure requirements for insurance contracts under the two frameworks.

Frequently Asked Questions

This section addresses specifics on how IFRS 17 influences the recognition and measurement of insurance contract liabilities and the subsequent implications for financial reporting.

How does IFRS 17 change the recognition and measurement of insurance contract liabilities compared to previous standards?

IFRS 17 introduces a consistent principle-based approach to the measurement of insurance contracts. It replaces prior models with a General Measurement Model, which aligns the recognition of income with the delivery of insurance services and requires entities to measure insurance contracts at current fulfillment value, which is a significant shift from the previous cost-based models.

What are the key steps for recognizing and measuring insurance contracts under IFRS 17?

The process for recognizing and measuring insurance contracts under IFRS 17 involves identifying the contract boundary, determining the groups of insurance contracts, and measuring them. Entities must assess the obligations, estimate the future cash flows, adjust for the time value of money, and consider non-financial risk. They must also recognize revenue as they provide coverage and incur claim liabilities.

Can you explain the treatment of incurred claims under IFRS 17 and how it affects the liability for these claims?

Under IFRS 17, incurred claims must be recognized when the insurer has an obligation to make payments for insurance events that occurred before the end of the reporting period. The liability for these claims is determined by estimating the present value of expected future cash flows and the risk adjustment for non-financial risk, which then reflects the insurer’s obligation more accurately.

In what ways does IFRS 17 require insurance contracts to be presented in financial statements, and what are the implications for disclosure?

IFRS 17 mandates that insurance contracts be presented on the balance sheet as either a contract asset or liability. Insurers must disclose the recognition and measurement basis for these contracts, including assumptions made and methods used. The standard emphasizes the transparency of the performance of insurance contracts and the risks associated with them.

What criteria must a contract meet to be considered an insurance contract under IFRS 17, and which entities are affected by this standard?

To be considered an insurance contract under IFRS 17, a contract must transfer significant insurance risk by compensating the policyholder for an adverse event. The scope of IFRS 17 affects entities issuing insurance contracts, including insurers and reinsurance companies, requiring an in-depth assessment of contract terms against the IFRS 17 criteria.

How does the implementation of IFRS 17 specifically impact the reported profitability and timing of revenue for insurance companies?

The implementation of IFRS 17 affects reported profitability and revenue timing because the recognition of revenue occurs as the service is provided, rather than when premiums are received. This can lead to differences in reported profit margins, particularly early in the life of an insurance contract, and places greater emphasis on service margin as a profitability measure.