IFRS 4, Insurance Contracts, mainly addresses the identification of insurance contracts by an entity that issues these contracts—which is not limited to insurance companies—and limited other recognition and measurement issues. It applies to insurance contracts issued, reinsurance contracts held and financial instruments issued with a discretionary participation feature. The matter of the actual accounting for insurance contracts is not addressed in IFRS 4.
IFRS 17, Insurance Contracts, was issued in May 2017 and amended in June 2020 to create a comprehensive standard to deal with the identification, recognition, measurement, presentation and disclosure of insurance contracts. IFRS 17 is effective for annual reporting periods beginning on or after January 1, 2023. Earlier adoption is permitted provided that the entity also applies IFRS 9, Financial Instruments, and IFRS 15, Revenue from Contracts with Customers, on or before the date of initial application of IFRS 17.
Source of IFRS |
IFRS 4 |
Cedant. The policyholder under a reinsurance contract.
Deposit component. A contractual component that is not accounted for as a derivative under IFRS 9 and would be within the scope of IFRS 9 if it were a separate instrument.
Direct insurance contract. An insurance contract that is not a reinsurance contract.
Discretionary participation feature. A contractual right to receive, as a supplement to guaranteed benefits, additional benefits:
Fair value. The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's-length transaction.
Financial guarantee contract. A contract that requires the issuer to make specified payments to reimburse the holder for a loss it incurs because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument.
Financial risk. The risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract.
Guaranteed benefits. Payments or other benefits to which a particular policyholder or investor has an unconditional right that is not subject to the contractual discretion of the issuer.
Guaranteed element. An obligation to pay guaranteed benefits included in a contract that contains a discretionary participation feature.
Insurance asset. An insurer's net contractual rights under an insurance contract.
Insurance contract. A contract under which one party (the insurer) 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.
Insurance liability. An insurer's net contractual obligations under an insurance contract.
Insurance risk. Risk, other than financial risk, transferred from the holder of a contract to the issuer.
Insured event. An uncertain future event that is covered by an insurance contract and creates insurance risk.
Insurer. The party that has an obligation under an insurance contract to compensate a policyholder if an insured event occurs.
Liability adequacy test. An assessment of whether the carrying amount of an insurance liability needs to be increased (or the carrying amount of related deferred acquisition costs or related intangible assets decreased), based on a review of future cash flows.
Policyholder. A party that has a right to compensation under an insurance contract if an insured event occurs.
Reinsurance assets. A cedant's net contractual rights under a reinsurance contract.
Reinsurance contract. An insurance contract issued by one insurer (the reinsurer) to compensate another insurer (the cedant) for losses on one or more contracts issued by the cedant.
Reinsurer. The party that has an obligation under a reinsurance contract to compensate a cedant if an insured event occurs.
Unbundle. Account for the components of a contract as if they were separate contracts.
An insurance contract is defined in IFRS 4 as a contract under which one party (the insurer) 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.
A contract creates sufficient insurance risk to qualify as an insurance contract only if there is a reasonable possibility that an event affecting the policyholder or other beneficiary will cause a significant change in the present value of the insurer's net cash flows arising from that contract. In considering whether there is a reasonable possibility of such significant change, it is necessary to consider the probability of the event and the magnitude of its effect. Also, a contract that qualifies as an insurance contract at inception or later remains an insurance contract until all rights and obligations are extinguished or expire. If a contract did not qualify as an insurance contract at inception, it should be subsequently reclassified as an insurance contract if, and only if, a significant change in the present value of the insurer's net cash flows becomes a reasonable possibility.
A range of other arrangements, which share certain characteristics with insurance contracts, would be excluded from any imposed insurance contracts accounting standard, since they are dealt with under other standards. These include financial guarantees (including credit insurance) measured at fair value; product warranties issued directly by a manufacturer, dealer or retailer; employers' assets and liabilities under employee benefit plans (including equity compensation plans); retirement benefit obligations reported by defined benefit retirement plans; contingent consideration payable or receivable in a business combination; and contractual rights or contractual obligations that are contingent on the future use of, or right to use, a non-financial item (for example, certain licence fees, royalties, lease payments and similar items).
IFRS 4 applies to all insurance contracts, including reinsurance. Thus, the standard does not relate only to insurance companies, but all entities engaging in insurance contracts.
IFRS 4 does not apply to product warranties issued directly by a manufacturer, dealer or retailer; employers' assets and liabilities under employee benefit plans and retirement benefit obligations reported by defined benefit retirement plans; contractual rights or obligations that are contingent on the future use of or right to use a non-financial item, as well as lessee's residual value guarantees on finance leases; financial guarantees entered into or retained on transferring financial assets or financial liabilities within the scope of IFRS 9; contingent consideration payable or receivable in a business combination; or direct insurance contracts that an entity holds as a policyholder.
IFRS 4 replaces what had been an indirect definition of an insurance contract under IAS 32 with a positive definition based on the transfer of significant insurance risk from the policyholder to the insurer. This definition covers most motor, travel, life, annuity, medical, property, reinsurance and professional indemnity contracts. Some catastrophe bonds and weather derivatives would also qualify, as long as payments are linked to a specific climatic or other insured future event that would adversely affect the policyholder. On the other hand, policies that transfer no significant insurance risk—such as some savings and pensions plans—will be deemed financial instruments, addressed by IFRS 9, regardless of their legal form. IFRS 9 also applies to contracts that principally transfer financial risk, such as credit derivatives and some forms of financial reinsurance.
There may be some difficulty in classifying the more complex products (including certain hybrids). To facilitate this process, the IASB has explained that insurance risk will be deemed significant only if an insured event could cause an insurer to pay significant additional benefits in any scenario, apart from a scenario that lacks commercial substance. As a practical matter, reporting entities should compare the cash flows from: (1) the occurrence of the insured event against (2) all other events. If the cash flows under the former are significantly larger than under the latter, significant insurance risk is present.
For example, when the insurance benefits payable upon death are significantly larger than the benefits payable upon surrender or maturity, there is significant insurance risk. The significance of the additional benefits is to be measured irrespective of the probability of the insured event, if the scenario has commercial substance. Reporting entities have to develop internal quantitative guidance to ensure the definition is applied consistently throughout the entity. To qualify as significant, the insurance risk also needs to reflect a pre-existing risk for the policyholder, rather than having arisen from the terms of the contract.
This requirement would specifically exclude from the cash flow comparison features such as waivers of early redemption penalties within investment plans or mortgages in the event of death. Since it is the contract itself that brought the charges into place, the waiver does not represent an additional benefit received for the transfer of a pre-existing insurance risk.
The application of this IFRS 4 definition may result in the redesignation of a significant fraction of existing insurance contracts as investment contracts. In other situations, the impact could be the opposite. For example, a requirement to pay benefits earlier if an insured event occurs could make a contract insurance; this means that many pure endowment contracts are likely to meet the definition of insurance. All told, insuring entities will need to set clear, consistent and justifiable contract classification criteria and rigorously apply these.
IFRS 4 imposes a liability adequacy test, which requires that at each reporting date the “insurer” must assess whether its recognised insurance liabilities are adequate, using then-current estimates of future cash flows under the outstanding insurance contracts. If as a result of that assessment it is determined that the carrying amount of insurance liabilities (less related deferred acquisition costs and related intangible assets, if appropriate—see discussion below) is insufficient given the estimated future cash flows, the full amount of such deficiency must be reported currently in earnings.
The standard defines minimum requirements for the adequacy test that is to be applied to the liability account. These minimum requirements are that:
In situations where the insuring entity's accounting policies do not require a liability adequacy test, or provide for a test that does not meet the minimum requirements noted above, then the entity is required under IFRS 4 to:
The IAS 37-based amount is the required minimum liability to be presented. Therefore, if the current carrying amount is less, the insuring entity must recognise the entire shortfall in current period earnings. The corresponding credit to this loss recognition will either decrease the carrying amount of the related deferred acquisition costs or related intangible assets or increase the carrying amount of the relevant insurance liabilities, or both, dependent upon the facts and circumstances.
In applying the foregoing procedures, any related reinsurance assets are not considered, because an insuring entity accounts for these separately, as noted later in this discussion.
If an insuring entity's liability adequacy test meets the minimum requirements set forth above, this test is applied at the level of aggregation specified above. On the other hand, if the liability adequacy test does not meet the stipulated minimum requirements, the comparison must instead be made at the level of a portfolio of contracts that are subject to broadly similar risks and which are managed together as a single portfolio.
For purposes of comparing the recorded liability to the amount required under IAS 37, it is acceptable to reflect future investment margins only if the carrying amount of the liability also reflects those same margins. Future investment margins are defined under IFRS 4 as being employed if the discount rate used reflects the estimated return on the insuring entity's assets, or if the returns on those assets are projected at an estimated rate of return, and discounted at a different rate, with the result included in the measurement of the liability. There is a rebuttable presumption that future investment margins should not be used; however, exceptions (see below) can exist.
When an insuring entity obtains reinsurance (making it the cedant), an asset is created in its financial statements. As with other assets, the reporting entity must consider whether an impairment has occurred as of the reporting date. Under IFRS 4, a reinsurance asset is impaired only when there is objective evidence that the cedant may not receive all amounts due to it under the terms of the contract, as a consequence of an event that occurred after initial recognition of the reinsurance asset, and furthermore the impact of that event is reliably measurable in terms of the amounts that the cedant will receive from the reinsurer.
When the reinsurance asset is found to be impaired, the carrying amount is adjusted downward and a loss is recognised in current period earnings for the full amount.
IFRS requires certain accounting practices to be adopted with regard to insurance contracts, but also allows other, existing procedures to remain in place under defined conditions. An insuring entity may, under the provisions of IFRS 4, change accounting policies for insurance contracts only if such change makes the financial statements more relevant to the economic decision-making needs of users and no less reliable or more reliable and no less relevant to those needs. Relevance and reliability are to be assessed by applying the criteria set forth in IAS 8.
To justify changing its accounting policies for insurance contracts, an insuring entity must demonstrate that the change brings its financial statements nearer to satisfying the criteria of IAS 8, but the change does not necessarily have to achieve full compliance with those criteria. The standard addresses changes in accounting policies in the context of current interest rates; continuation of existing reporting practices; prudence; future investment margins; and “shadow accounting.” These are discussed in the following paragraphs.
Regarding interest rates, IFRS 4 provides that an insuring entity is permitted, although it is not required, to change its accounting policies such that it remeasures designated insurance liabilities to reflect current market interest rates, and recognises changes in those liabilities in current period earnings. It may also adopt accounting policies that require other current estimates and assumptions for the designated liabilities. IFRS 4 permits an insuring entity to change its accounting policies for designated liabilities, without consistently applying those policies to all similar liabilities, as the requirements under IAS 8 would suggest. If the insuring entity designates liabilities for this policy choice, it must continue to apply current market interest rates consistently in all periods to all these liabilities until they are later eliminated.
An unusual feature of IFRS 4 is that it offers affected reporting entities the option to continue with their existing accounting policies. Specifically, an insuring entity is allowed to continue the following practices if in place prior to the effective date of IFRS 4:
The concept of prudence, as set forth in IFRS 4, is meant to excuse an insuring entity from a need to change its accounting policies for insurance contracts to eliminate excessive prudence (i.e., conservatism). However, if the insuring entity already measures its insurance contracts with sufficient prudence, it is not permitted to introduce additional prudence following adoption of IFRS 4.
The matter of future investment margins requires some explanation. Under IFRS 4 it is clearly preferred that the measurement of insurance contracts should not reflect future investment margins, but the standard does not require reporting entities to change accounting policies for insurance contracts to eliminate future investment margins. On the other hand, adopting a policy that would reflect this is presumed to be improper (the standard states that there is a rebuttable presumption that the financial statements would become less relevant and reliable if an accounting policy that reflects future investment margins in the measurement of insurance contracts is adopted, unless those margins affect the contractual payments). The standard offers two examples of accounting policies that reflect those margins. The first is using a discount rate that reflects the estimated return on the insurer's assets, while the second is projecting the returns on those assets at an estimated rate of return, discounting those projected returns at a different rate and including the result in the measurement of the liability.
IFRS 4 states that the insuring entity could possibly overcome this rebuttable presumption if the other components of a change in accounting policies increase the relevance and reliability of its financial statements sufficiently to outweigh the decrease in relevance and reliability caused by the inclusion of future investment margins. As an example, it cites the situation where the existing accounting policies for insurance contracts involve excessively prudent (i.e., conservative) assumptions set at inception, and a statutory discount rate not directly referenced to market conditions and ignore some embedded options and guarantees. This entity might make its financial statements more relevant and no less reliable by switching to a comprehensive investor-oriented basis of accounting that is widely used and involves current estimates and assumptions; a reasonable (but not excessively prudent) adjustment to reflect risk and uncertainty; measurements that reflect both the intrinsic value and time value of embedded options and guarantees; and a current market discount rate, even if that discount rate reflects the estimated return on the insuring entity's assets.
The actual ability to overcome IFRS 4's rebuttable presumption is fact dependent. Thus, in some measurement approaches, the discount rate is used to determine the present value of a future profit margin, which is then attributed to different periods using a formula. In such approaches, the discount rate affects the measurement of the liability only indirectly, and the use of a less appropriate discount rate has limited or no effect on the measurement of the liability at inception. In yet other approaches, the discount rate determines the measurement of the liability directly, and because the introduction of an asset-based discount rate has a more significant effect, it is highly unlikely that an insurer could overcome the rebuttable presumption noted above.
Finally, there is the matter of shadow accounting. According to IFRS 4, an insurer is permitted, but not required, to change its accounting policies so that a recognised but unrealised gain or loss on an asset affects those measurements in the same way that a realised gain or loss does. This is because, under some accounting models, realised gains or losses on an insurer's assets have a direct effect on the measurement of some or all of: (1) its insurance liabilities; (2) related deferred acquisition costs; and (3) related intangible assets. IFRS 4 provides that the related adjustment to the insurance liability (or deferred acquisition costs or intangible assets) may be recognised in equity if, and only if, the unrealised gains or losses are recognised directly in equity.
Specific requirements pertain to unbundling of elements of insurance contracts, and dealing with embedded derivatives, options and guarantees.
Unbundling refers to the accounting for components of a contract as if they were separate contracts. Some insurance contracts consist of an insurance component and a deposit component. IFRS 4 in some cases requires the reporting entity to unbundle those components, and in other fact situations provides the entity with the option of unbundled accounting. Specifically, unbundling is required if both the following conditions are met:
On the other hand, unbundling is permitted, but not required, if the insuring entity can measure the deposit component separately but its accounting policies require it to recognise all obligations and rights arising from the deposit component, regardless of the basis used to measure those rights and obligations.
Unbundling is actually prohibited if an insuring entity cannot measure the deposit component separately. If unbundling is applied to a contract, the insuring entity applies IFRS 4 to the insurance component of the contract, while using IFRS 9 to account for the deposit component of that contract.
IFRS 4 prohibits the recognition of a liability for any provisions for possible future claims, if those claims arise under insurance contracts that are not in existence at the reporting date. Catastrophe and equalisation provisions are thus prohibited, because they do not reflect loss events that have already occurred and therefore recognition would be inconsistent with IAS 37. Loss recognition testing is required for losses already incurred at each date of the statement of financial position, as described above. An insurance liability (or a part of an insurance liability) is to be removed from the statement of financial position only when it is extinguished (i.e., when the obligation specified in the contract is discharged or cancelled or expires).
In terms of display, offsetting of reinsurance assets against the related insurance liabilities is prohibited, as is offsetting of income or expense from reinsurance contracts against the expense or income from the related insurance contracts.
Insurance contracts sometimes contain a discretionary participation feature, as well as a guaranteed element. (That is, some portion of the return to be accrued to policyholders is at the discretion of the insuring entity.) Under the provisions of IFRS 4, the issuer of such a contract may, but is not required to, recognise the guaranteed element separately from the discretionary participation feature. If the issuer does not recognise them separately, it must classify the entire contract as a liability. If, on the other hand, the issuer classifies them separately, it will classify the guaranteed element as a liability. If the entity recognises the discretionary participation feature separately from the guaranteed element, the discretionary participation feature can be classified either as a liability or as a separate component of equity; the standard does not specify how the decision should be reached. In fact, the issuer may even split that feature into liability and equity components, if a consistent accounting policy is used to determine that split.
When there is a discretionary participation feature which is reported in equity, the reporting entity is permitted to recognise all premiums received as revenue, without separating any portion that relates to the equity component. Changes in the guaranteed element and in the portion of the discretionary participation feature classified as a liability are to be reported in earnings, while changes in the part of the discretionary participation feature classified as equity are to be accounted for as an allocation of earnings, similar to how minority interest is reported.
If the contract contains an embedded derivative within the scope of IFRS 9, that standard must be applied to that embedded derivative.
Under the provisions of IFRS 4, insuring entities must disclose information that identifies and explains the amounts in its financial statements arising from insurance contracts. This is accomplished by disclosure of accounting policies for insurance contracts and related assets, liabilities, income and expense; of recognised assets, liabilities, income and expense (and, if it presents its statement of cash flows using the direct method, cash flows) arising from insurance contracts. Additionally, if the insuring entity is a cedant, it must also disclose gains and losses recognised in profit or loss on buying reinsurance; and, if the cedant defers and amortises gains and losses arising on buying reinsurance, the amortisation for the period and the amounts remaining unamortised at the beginning and end of the period.
Disclosure is also required of the process used to determine the assumptions that have the greatest effect on the measurement of the recognised amounts described above. When practicable, quantified disclosure of those assumptions is to be presented as well. The effect of changes in assumptions used to measure insurance assets and insurance liabilities is required, reporting separately the effect of each change that has a material effect on the financial statements.
Finally, reconciliation of changes in insurance liabilities, reinsurance assets and, if any, related deferred acquisition costs are mandated by IFRS 4.
Regarding the amount, timing and uncertainty of cash flows, the entity is required to disclose information that helps users to understand these matters as they result from insurance contracts. This is accomplished if the insuring entity discloses its objectives in managing risks arising from insurance contracts and its policies for mitigating those risks.
IFRS 4 was amended September 2016 to create a temporary exception for insurers to remain applying IAS 39 rather than IFRS 9 for annual periods beginning before January 1, 2021, if the insurer's activities are predominantly connected with insurance. If the entities activities are not predominantly connected with insurance, an overlay approach may be applied, under which the difference between the IFRS 9 and IAS 39 treatment is recognised in other comprehensive income.
The temporary exemptions from IFRS 9 and the overlay approach are also available to an issuer of a financial instrument that contains a discretionary participation feature.
An insurer may apply the temporary exemption from IFRS 9 if it has not previously applied any version of IFRS 9 (except for applying the requirement in IFRS 9 that the effect of changes in credit risk of a liability are recognised in other comprehensive income for financial liability designated at fair value through profit or loss) and its activities are predominantly connected with insurance, at its annual reporting date that immediately precedes April 1, 2016, or at a subsequent annual reporting date specified.
After April 1, 2016 an entity applying the temporary exception should reassess whether its activities are predominantly connected with insurance at a subsequent annual reporting date if there was a change in the entity's activities. An entity that previously did not qualify for the temporary exemption from IFRS 9 is permitted to reassess whether its activities are predominantly connected with insurance at subsequent annual reporting dates before December 31, 2018 only if there was a change in the entity's activities during that annual period. The standard provides additional guidance on what constitutes a change in an entity's activities.
If an entity no longer qualifies for the temporary exemption from IFRS 9 as a result of a reassessment, then the entity is permitted to continue to apply the temporary exemption from IFRS 9 only until the end of the annual period that began immediately after that reassessment. An insurer that previously elected to apply the temporary exemption from IFRS 9 may at the beginning of any subsequent annual period irrevocably elect to apply IFRS 9.
An entity applying the temporary exception from IFRS 9 may apply the requirement in IFRS 9 that the effect of changes in credit risk of a liability are recognised in other comprehensive income for financial liability designated at fair value through profit or loss.
An insurer's activities are predominantly connected with insurance if:
Liabilities connected with insurance comprise:
A first-time adopter of IFRS may apply the temporary exemption from IFRS 9 if it meets the criteria for applying the temporary exemption as described above.
Situations may exist where an insurer applies the temporary exceptions from IFRS 9 but its associates or joint ventures do not, or vice versa. For annual periods beginning before January 1, 2021, the entity is permitted to retain the relevant accounting policies applied by the associate or joint venture as follows:
An entity may apply the requirements separately for each associate or joint venture.
When an entity uses the equity method to account for its investment in an associate or joint venture:
An entity may apply the requirements above separately for each associate or joint venture.
The disclosure objective for an insurer that elects to apply the temporary exemption from IFRS 9 is to disclose information to enable users of financial statements:
To achieve this disclosure objective, an insurer shall disclose:
An insurer is permitted to apply the overlay approach to designated financial assets. An insurer that applies the overlay approach shall:
An insurer may elect to apply the overlay approach only when it first applies IFRS 9. An insurer may also apply the overlay approach if the temporary exception from IFRS 9 is no longer available because the insurers' activities are no longer predominantly connected with insurance.
An insurer shall present the amount reclassified between profit or loss and other comprehensive income applying the overlay approach:
A financial asset is eligible for designation for the overlay approach if the following criteria are met:
An insurer may designate an eligible financial asset for the overlay approach when it elects to apply the overlay approach. An insurer is permitted to designate eligible financial assets for the overlay approach on an instrument-by-instrument basis. Subsequently, it may designate an eligible financial asset for the overlay approach when:
When relevant, for the purposes of applying the overlay approach to a newly designated financial asset in Point 2., above:
An entity shall continue to apply the overlay approach to a designated financial asset until that financial asset is derecognised. However, an entity:
When an entity de-designates a financial asset, it shall reclassify from accumulated other comprehensive income to profit or loss as a reclassification adjustment any balance relating to that financial asset.
If an entity stops using the overlay approach applying by election or because it is no longer an insurer, it shall not subsequently apply the overlay approach. An insurer that has elected to apply the overlay approach but has no eligible financial assets may subsequently apply the overlay approach when it has eligible financial assets.
The disclosure objective is that an insurer that applies the overlay approach shall disclose information to enable users of financial statements to understand:
To achieve the disclosure objective, an insurer shall disclose:
If an entity applied the overlay approach when accounting for its investment in an associate or joint venture using the equity method, the entity shall disclose the following, in addition to the information required by IFRS 12:
Reclassifying an amount between profit or loss and other comprehensive income applying the overlay approach may have consequential effects for including other amounts in other comprehensive income, such as income taxes. An insurer shall apply the relevant IFRS, such as IAS 12, Income Taxes, to determine any such consequential effects.
If a first-time adopter elects to apply the overlay approach, it shall restate comparative information to reflect the overlay approach if, and only if, it restates comparative information to comply with IFRS 9.
The temporary exemption from IFRS 9 is for annual periods beginning on or after January 1, 2018. An entity that discloses the information required for this temporary exemption from IFRS 9 shall use the transitional provisions in IFRS 9 that are relevant to making the assessments required for those disclosures. The date of initial application for this purpose shall be deemed to be the beginning of the first annual period beginning on or after January 1, 2018.
An entity shall apply the amendments, which permit insurers to apply the overlay approach to designated financial assets, when it first applies IFRS 9. An entity that elects to apply the overlay approach shall:
IFRS 17 is applicable to:
IFRS 17 is not applicable to:
Some fixed fee service contracts might be identified as insurance contracts. An entity may choose to apply IFRS 15 and not IFRS 17 if the following conditions are met:
This choice is made on a contact-by-contact basis and is irrevocable.
In certain insurance contacts, the compensation for insurance events might be limited to the amount of obligation required to settle the contacts. The entity could choose to apply IFRS 17 or IFRS 9. This choice is made for each portfolio of insurance contracts and is irrevocable.
IFRS 17 in principle transfers all the requirements to identify an insurance contract from IFRS 4. New rules are created for the unbundling of deposits and non-insurance revenue components. The following process is followed for unbundling:
Investment components are distinct if the components are not highly interrelated and a contract with equivalent terms is, or could be, sold in the market or jurisdiction. Components are highly interrelated if the one component could not be measured without the other, or the policyholder is not able to benefit from the one component unless the other is also present.
The benchmark approach in IFRS 17 is based on the principle that insurance contracts create a bundle of rights and obligations that work together to generate a package of cash inflows (premiums) and outflows (benefits and claims). An insurer would apply to that package of cash flows a measurement approach, called the fulfilment value approach, that uses the following building blocks:
Components of the building block approach are defined in IFRS 17 as follows:
Component | Definition |
Fulfilment cash flows | An explicit, unbiased and probability-weighted estimate (i.e., expected value) of the present value of the future cash outflows minus the present value of future cash inflows that arises as the entity fulfils insurance contracts, including a risk adjustment for non-financial risks. |
Risk adjustment for non-financial risks | The compensation an entity requires for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk as the entity fulfils the insurance contracts. |
Contract service margin | A component of the carrying amount of the asset or liability for a group of insurance contacts presenting the unearned profits the entity will recognise as it provides services under the insurance contract |
The first three building blocks are regarded to be the fulfilment cash flows and the contract service margin reflects the entity's risk-adjusted expected profit from the contract. The contract service margin eliminates the recognition of any gain at inception of the contract. The contractual service margin is therefore the unearned profits on the contract and is reduced as the profits are earned over the duration of the contract. The contract service margin is updated for changes in future service-related estimations. The effect of the fulfilment value approach is that the profit from a group of insurance contracts is spread over the period the entity provides insurance coverage, and therefore is released from insurance risks.
However, if a group of contracts is loss-making (onerous), the loss is recognised immediately. A group of insurance contracts become onerous when the contact service margin is eliminated because of unfavourable changes in fulfilment cash flows.
Cash flows within the boundary of insurance contracts should be included in the fulfilment value when:
Cash flows within the boundary of insurance contracts are those that are directly related and include:
The following cost flows are, however, specifically excluded from the boundary of insurance contracts.
The estimation of the future cash flows is adjusted to reflect the time value of money and the financial risks associated with the cash flows not adjusted in the cash flows.
The risk adjustment for non-financial risk reflects the compensation an entity bears for the uncertainty in the amount and timing of the cash flows arising from non-financial risk.
Insurance acquisition cash flows that are directly attributable to a group of insurance contracts are allocated on a systematic or rational basis to the group of insurance contracts and therefore included in the fulfilment value if not paid. An asset is created for such acquisition cash flows incurred before the group of insurance contracts is recognised. The asset is transferred when the group is recognised and since the cost are incurred will reduce the contact service margin that is recognised over the insurance service period.
Such recognised acquisition cost asset is assessed for recoverability at the end of each reporting period and any impairment or reversal is recognised in profit or loss.
A simplified premium allocation approach allows an entity to measure the amount relating to remaining service by recognising the unearned premiums received as a liability. The premium allocation approach is applicable when one of the following two options is applicable for entities that:
Option one may not be applied when significant variance in fulfilment cash flows is expected. The coverage period of one year and less is, however, problematic since in unclear instances the assessment is based on when the boundary of an insurance contract end. The boundary of insurance contracts ends when the substantive rights in the contracts are completed:
Under the premium allocation approach acquisition cost might be expenses, if the coverage period for each contract in the group is not more than a year for each contact in the group. If not expensed, the unamortised acquisition cash flows reduce the liability for remaining coverage.
Insurance contracts with the same or related counterparty achieving an overall commercial effect might be combined to report the substance of such contracts.
Insurance contracts are classified in different portfolios to apply the applicable measurement basis based on three steps:
IFRS 17 determines that a group of insurance contracts is recognised at the earlier of:
Under both the fulfilment value approach and the premium allocation approach a liability for remaining coverage and a liability for incurred claims must be recognised. These terms are defined as follows:
Liability for remaining coverage | An entity's obligation to investigate and pay valid claims under existing insurance contacts for insured events that have not yet occurred (i.e., the obligation that relates to the unexpired portion of the coverage period). |
Liability for incurred claims | An entity's obligation to investigate and pay valid claims for insured events that have already occurred, including events that have occurred but for which claims have not been reported and other incurred insurance expenses. |
Under the fulfilment value approach, the liability for remaining coverage is the fulfilment value determined for a group of contracts plus the contact service margin, while for the premium allocation approach it is the revenue received in advance (unearned premiums) minus non-expensed acquisition cost (if not expensed), which are amortised over the service period. Under the fulfilment value approach, acquisition cost is deducted from the contract service margin and therefore spread as the net profit is recognised.
Under the fulfilment value approach, income and expenses are recognised as follows:
Under the premium allocation approach insurance revenue is recognised for premiums earned.
The liability for incurred claims for both the fulfilment value approach and the premium allocation approach is the future expected cash flows for claims incurred plus a risk adjustment for non-financial risks. The liability for incurred claims includes both claims reported but which are not paid or settled and claims incurred but not reported (IBNR). The liability for incurred claims is discounted if it is payable after 12 months.
Income and expenses are recognised for the following changes in the liability for incurred claims for both the fulfilment value and the premium allocation approaches:
Reinsurance contracts issued by the insurance entity are treated similarly to other direct insurance business and included in the liability for remaining coverage and the liability for incurred claims.
Reinsurance contracts held by the insurance entity are treated similarly to insurance contracts but oppositely, thus either the fulfilment value or the premium allocation approach is correspondently used. Reinsurance contracts cannot be onerous.
A group of reinsurance contracts held are recognised at the earlier of the following:
If the fulfilment value approach is followed, no unearned profit is created but a net cost or gain on purchasing a reinsurance contract, which represents the contact service margin. The net cost is, however, expensed on initial recognition if it relates to events occurring before the recognition date. Net gains are created for reinsurance contracts for which the related onerous insurance contracts are recognised to offset the onerous contract loss on the related insurance contract. A loss-recovery component of a reinsurance asset is created for related onerous insurance contracts that will be recovered in the future.
The risk adjustment for non-financial risk is determined as the risk transferred by the holder to the issuer of the related contracts. Reinsurance contracts should also be assessed for the risk of non-performance. Changes in the fulfilment cash flows due to non-performance do not relate to future services and therefore should not adjust the contract service margin.
The simplified premium allocation approach could be applied for reinsurance contracts if one of the following conditions applies:
In applying the premium allocation approach to reinsurance contracts held, the features that differ from insurance contracts issued are considered. Expenses rather than revenue is therefore created. If the related insurance contract is onerous, the carry amount of the asset for remaining coverage is adjusted and not the contract service margin.
IFRS 17 also deals with contracts with participation features. For insurance contracts with direct participation features the entity's share of the changes in the fair value of the underlying items is included in the estimation of the future cash flows and therefore effect the contract service margin. For investment contracts with discretionary participation features, the requirements for insurance contracts are modified as follows:
When the terms of an insurance contract are modified, the old contract is derecognised and a new contract is recognised if strict conditions are met that changes the classification, unbundling of components, the contract boundary, the grouping or the approach applicable to the contract. If none of the modification conditions are met, the related changes in cash flows are included in the normal estimation of cash flows.
An insurance contract is derecognised when the contract is extinguished or any of the modification conditions applies.
The presentation of an insurance entity's performance is divided into insurance service results and financial results to separate them. The financial results are further divided into finance (investment) results and finance expense. The presentation in the income statement will then be as follows:
Insurance revenue | X |
Incurred claims and other expenses | (X) |
Insurance service results | X |
Investment income | X |
Insurance finance expenses | (X) |
Net financial results | X |
Profit or loss | X |
The new format of the income statement is applicable to both entities that previously were regarded as short-term or long-term insurers. The IASB wants to create comparability between insurance and other entities. Revenue is regarded as the amount charged for insurance coverage as it is earned. Revenue should therefore specially be calculated when the fulfilment value approach is followed. Under the premium allocation approach revenue represents the earned premiums. Insurance finance expenses resulting from changes in interest rates may be transferred to other comprehensive income.
For reinsurance contracts held, reinsurance contract income (amounts recovered) and expenses (premiums paid over and other related expense) are disclosed separately on the face of the income statement, but alternatively may be presented as a single figure with the split in the related note. Insurance revenue might therefore not be reduced by premiums forwarded to reinsurance companies.
Portfolio of insurance and reinsurance contracts are recognised and presented separately as assets and liabilities. The following insurance assets and liabilities needs to be presented separately on the face of the statement of financial position:
The split of the insurance liability between the liability for remaining coverage and the liability for incurred claims are therefore made in the notes. Similarly, for reinsurance contract the split between the asset for remaining coverage and asset for incurred claims are also made in the notes. An acquisition cost asset (liability) is only created for acquisition cost incurred before the related contract is recognised. If the related contract is recognised, the acquisition cost is deducted from the residual margin for the fulfilment value approach and from the unearned premiums for the premium allocation approach (if not expensed immediately).
The disclosure objective is to provided information, together with the presentation, that gives a basis to assess the effect of insurance contract and related contracts in the scope of IFRS on the financial position, financial performance and cash flows of an entity. In achieving the objective quantitative and qualitative information are provided regarding:
IFRS 17 provides detail disclosure regarding each of these aspects.
IFRS 17 should be applied retrospectively on transition. However, if impracticable, a modified retrospective approach or a fair value approach may be applied. Special transition rules are also applicable if an entity applies IFRS 17 and IFRS 19 for the first time on the same date.
The US GAAP guidance at ASC 944, Financial Services—Insurance, covers insurance contracts issued by insurance-type companies, that is they have qualified as an insurance company through registration of their insurance domiciling state. If you are an insurance company then you would comply with ASC 944 with respect to insurance activities, acquisition costs, claim costs and liabilities for future policy benefits, policyholder dividends and separate accounts. If you do not fall under ASC 944 then your revenue and expense are accounted for under other US GAAP codification. Additionally, US GAAP does not consider an insurance contract to be a financial instrument whereas IFRS does.
ASC 944 lists four methods for recognition of premium revenue and contract liabilities: one method was developed for short-duration contract accounting and three methods for long-duration contract accounting (i.e., traditional life, universal life and participating contracts). Generally, the four methods reflect the nature of the insurance entity's obligations and policyholder rights under the provisions of the contract. Acquisition costs are amortised over the life of the policy and subject to impairment based on the adequacy of premiums for policies in light of circumstances at the balance sheet date.
Short-duration contracts, which are for a short period, usually one year, generally require revenue recognition on a straight-line basis. Long-duration contracts, in most cases, require offsetting of receivables or cash against unrecognised revenue. This revenue is recognised commensurate with the risk insured. Another feature of long-duration contract accounting is that for each reporting period, liabilities for coverage risk are assessed and increased if needed. The offset is recognised in the current period expense.
Current US GAAP has special disclosure requirements that are required supplementary information for short-term contracts. Long-term contracts requirements are covered by ASU 2018-12 Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts.
US GAAP contains a provision to ensure there are adequate reserves to cover premiums under what is called a premium deficiency test, which is required. The premium deficiency test would be adequate if used for the IFRS's “liability adequacy test.”
US GAAP also covers accounting for reinsurance contracts. These arrangements transfer some or all of the risk of insurance to a third party (not the insured). Generally, the accounting is similar to insurance contracts, although there are specific criteria for determining if the original insurer has transferred the risks to the reinsurer.
The concept of separate accounts specifies accounting when assets are specifically segregated for a particular policyholder, for example variable annuity contracts that guarantee some minimum level of benefits.