The IFRS 17 general accounting model and its objectives
IFRS 17 – Insurance Contracts was issued by the International Accounting Standards Board in May 2017; the topic has been on the agenda since 2001. It replaces IFRS 4 and will be effective for accounting periods commencing on or after 1 January 2021. In applying a general accounting model for all insurance contracts (albeit with some modifications and exceptions), the standard establishes a framework for the recognition, measurement and disclosure of insurance contracts (as defined and within the scope of IFRS 17). The overall objective is to provide a basis for users of financial statements to assess the effect that entering into insurance contracts will have on an issuer’s financial position, performance and cash flow.
IFRS 17 – Insurance Contracts presents a huge change in reporting practice for a very large, very old, multi-national industry with many diverse contracts and accounting practices. The degree of the implementation challenge will depend on the type and variety of insurance business conducted by an insurer. The purpose of this article is to try to shed some light on how the general model works and identify some potential problem areas.
How the IFRS 17 general model works
To see how different this is compared to existing practice let us consider the following simple illustration:
|An insurance entity with a 31/12 year-end issue a group of insurance contracts on 1st January 2021.
• Premiums are £240 per annum all to be paid on 1st January 2021.
• Coverage period is 2 years starting 1st January 2021.
• The entity forecasts that claims will be £160 per annum.
• Actual claims of £114 and £148 were paid in 2021 and 2022 respectively.
Current practice is to spread the premium income over the coverage period and to recognise a liability for in the balance sheet. Claims incurred are expensed against the premium income in the income statement each year.
|Income statement (P or L)||Balance sheet liability (2021 to 22)|
|Earned premiums||240||240||P or l revenue||240|
|Claims expense||(114)||(148)||2022||P or l revenue||240|
|Net pre-tax income||126||92|
What the general model does is to break down the liability into its component parts (often called “building blocks”). These are measured on initial recognition and then “amortised” over the coverage period.
The building blocks reflect the way in which the premiums charged to customers are priced. Using our example, the insurance entity:
- expects to pay claims of £320 (2 x £160) – the future net cash flows
- will require compensation of £24 for bearing the uncertainty inherent in the amount and timing of those cash flows – this is what IFRS 17 terms the non-financial risk adjustment
- wants to earn £136 profit on this group of contracts – the contract service margin
The premium is therefore £480 being the total of these.
On initial recognition the building block numbers are re-arranged as follows:
|The net cash flows [NCF] (480– 320)||160|
|The non-financial risk adjustment [NFRA]||(24)|
|The contractual service margin [CSM]||(136)|
On 1st January 2021 these will be recorded in a liability for remaining coverage (LCR) account together with the premiums received:
|Balance at 1/1/21||(320)||(24)||(136)||(480)|
These amounts are now amortised through the income statement over the coverage period. In the interests of simplicity we will do this on a straight line basis:
|Liability for remaining coverage||NCF||NFRA||CSM||Total|
|2X21 – P&L revenue||160||12||68||240|
|2X22 – P&L revenue||160||12||68||240|
|Income statement (P or L)||2021||2022|
|To cover claims||160||160|
|Amortisation of NFRA||12||12|
|Recognition of CSM||68||68|
At this point you are probably thinking what is the big deal here? More detailed presentation for sure but is it really that different?
For short term insurance contracts, the difference in the numbers will very likely be minimal compared to existing practice. In fact, IFRS 17 accepts this in allowing a simpler premium allocation approach for groups of such contracts so long as the numbers approximate to those under the general model and the coverage period is no more than one year.
A main source of the differences between old and new accounting practice lies in the net cash flow component of the liability for remaining coverage. This is for 2 reasons:
|1. The amount for future cash flows must be remeasured at each reporting date||2.The amount for future cash flows must be discounted to present value in order to reflect the time value of money|
Some further application issues
Identifying the unit of account
IFRS 17 applies a forensically wrought definition of an insurance contract, central to it being the fact that it must transfer insurance risk from the holder to the issuer.
The problem is that some contracts with customers will include insurance contracts in a bundle with other elements that do not transfer insurance risk. These elements (such as deposit components) must be unbundled and accounted for using the appropriate IFRS standard (IFRS 9 or 15 usually).
Finally (and this is a big one for preparers) the IFRS 17 accounting rules are to applied to groups of contracts and not individual ones. Insurers will firstly have to identify portfolios of contracts and then, within each portfolio, allocate contracts to time buckets (often called cohorts). Contracts issued more than one year apart may not be included 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.) Each cohort is divided into three groups reflecting the extent to which they are or could become onerous. The IFRS 17 accounting rules are applied to each group.
Insurance entities are expressing concern about how to apply IFRS 17 to reinsurance contracts held. Generally, IFRS 17 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 so simple for non-proportional and excess of loss reinsurance.
Other application issues for preparers include how to:
- account for contracts with participation features;
- apply the transitional rules;
- assemble the data necessary to construct the extensive qualitative and quantitative disclosures required by the standard.
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