The last update on accounting for insurance contracts was in 2004 with the IFRS 4, and it has proven to be incompetent in today’s highly complex environment. Thus, the International Accounting Standards Boards (IASB or Board) has developed a special project which aimed at: 

• Introducing a single IFRS accounting model for all types of insurance contracts 
• Increasing transparency  
• Aligning as much as possible insurance accounting with the general IFRS accounting of other industries 

The special project is named IFRS 17 Insurance Contracts (IFRS 4 Phase II or the Standard) – an International Financial Reporting Standards issued by the IASB on 18 May 2017. It will replace IFRS 4 and related interpretations. The result will be a complete overhaul of all insurers’ financial statements. Significant activities are already underway to implement the Standard. 

The objective of IFRS 17 is to establish principles for the recognition, measurement, presentation, and disclosure of insurance contracts. The Standard requires insurers to provide consistently and transparently measured information in all insurance contracts (insurance liabilities need to be measured at the current fulfilment value) and disclose them using a more uniform presentation. 

Under IFRS17, insurance contracts will: 

• Reflect fundamental economics with relevant and transparent information, updated assumptions, options and guarantees 
• Increase transparency about profitability by defining the source of earnings listed in the income statement, and contracts are split into groups or cohorts based on sets of criteria 
• Increase comparability among insurers, subsidiaries, and industries 

• Insurance contract: an agreement under which a customer (the policyholder) transfer significant insurance risk to the insurer; and the insurer (the issuer) agrees to compensate the policyholder if a specified unexpected future event occurs and harms the policyholder. 
• Insurance risk: non-financial risks that are transferred from the policyholder to the insurer. 
• Contractual service margin: represents the service the insurer provides and the unearned profit of a group of insurance contracts. It is presented in the balance sheet and recognised in the income statement. 
• Coverage period: the insurance period that the insurer promises to provide their services.
• Fulfilment cash flows: estimated values (after taking into account the timing and risks) the insurer expects to receive from premiums, claims, benefits, or expenses.
• Liability for remaining coverage: the insurer’s obligation to provide services under insurance contracts.
• Liability for incurred claims: the insurer’s obligation to pay amounts related to services provided.
• Portfolio of insurance contracts: groups of insurance contracts that are subject to similar risks and managed together.
• Risk adjustment for non-financial risk: the insurer’s compensation for bearing the insurance risk. 

Each element of a contract, its size, coverage structure, expected profitability can affect how insurers report their Contractual Service Margin (CSM). How contracts are aggregated or grouped can also impact the size and behaviour of CSM. 

Grouping of contracts can limit the offsetting of profitable contracts against ill-fated ones, which is the subject of debate as it requires insurers to apply different reporting requirements as well as disclosing the onerous groups and their liabilities. 

Thus, the Board has introduced IFRS 17's level of aggregation as guidelines to calculate and adjust CSM for grouping contracts.  

When classifying contract groups, the Standards requires insurers to follow these three criteria: 

1. Product portfolio

Clustering contracts that have the same risk types and managed together. 

2. Degree of profitability

Which is defined using the following principles:

• Groups of contracts that are onerous at the initial recognition 
• Groups of contracts that have no significant possibility of becoming onerous at the initial recognition 
• Groups of remaining contracts 

3. Year of issue

Contracts that are issued more than one year apart cannot belong to the same assortment. Additionally, groups of contracts that meet multiple profitability criteria must be further classified into smaller annual or quarter cohorts, which typically represent an issuing period of one year or less. 

Above, we mentioned the word "at initial recognition". What does this mean? In short, insurers need to identify which groups the insurance contracts belong to at the earliest time possible, which could be: 

• At the beginning of the coverage period of the group contracts 
• On the date when the first payment from a policyholder in the group becomes due 

• When the group becomes onerous 

Once groups are established, they cannot be reassessed or modified for the entirety of the coverage period. 

Under IFRS 17, there are three measurement approaches to help insurers define the value of their insurance contracts: 

• The General Measurement Model (or Building Block Approach) – for the majority of long-term contracts
• The Premium Allocation Approach – for the majority of short-term (less than one year) contracts
• The Variable Fee Approach – for contracts with direct participation features 

General Measurement Model (GMM) or Building Block approach 

The model can be used for any types of insurance contracts, including reinsurance. Thus, it is the default model unless the insurer chooses to use a different variation, which then needs a justification to explain the selection. 

The model aims at providing better comparability and transparency about the profitability of insurance contracts as well as better visibility into the insurer's financial health. 

The approach is also called the Building Block approach as it breaks down its measurement components into blocks, such as: 

• Future cash flows (in-flows, out-flows) 
• Discounting rate 
• Risk adjustment 
• The contractual service margin (CSM) 

In simple terms, the insurance contract value is calculated by totalling all of the above components: 

Fulfilment cash flows (future cash flows + discounting rate + risk adjustment) + CSM [source] 

The model helps determine the risk-adjusted present value of future cash flows (fulfilment cash flows) that the insurer expects to receive after the insurance contract is fulfilled. 

The cash flows should be discounted to reflect the time value of money and any financial risk, while the risk adjustment helps to justify any non-financial risks. 

The contract becomes loss or onerous when the fulfilment cash flows are negative or resulted in no CSM. 

Premium Allocation Approach (PAA) 

Viewed as the simplified version of the GMM, the insurer can use PAA for a group of contracts if and only if: 

• At the initial recognition, the coverage period of each contract in the group is one year or less. 
• At the initial recognition, the insurer expects the liability for remaining coverage for the group measured by PAA would not be materially different from the result of GMM. 

The "not materially different" criterion is violated if, at the initial recognition of the group of contracts, the insurer expects a significant variation in the fulfilment cash flows, which would affect the measurement of the liability for remaining coverage during the period before a claim is incurred. 

All in all, the PAA follows GMM's principles but does not use the CSM concept. Instead, the liability for the coverage period is measured based on premiums received during the period. 

The PAA calculation can be mapped as follow: 

Akin to premium (less acquisition costs) unearned + Risk adjustment + Discounting + Best estimate of fulfilment cash flows [source] 

Variable Fee Approach (VFA) 

VFA is an alternative method to the GMM designed to cater to insurance contracts with direct participation features (direct participating contracts). 

Direct participating contracts are investment-related service contracts that at the initial recognition: 

• Include contractual terms that specify the policyholder participates in the investment of a clearly identified pool of underlying items. 

• The insurer expects to pay the policyholder a sum that is equal to the fair value of the underlying items less a variable fee for service; and 

• The insurer expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in fair value of the underlying items. 

"A clearly identified pool of underlying items" can comprise any items, such as a reference portfolio of assets, the net assets of the entity or a subsidiary within the group that is the reporting entity. 

VFA introduces the "variable fee" concept, which in simple terms, is a fee for services the insurer provides. The fee comprises the insurer's share of the fair value of the underlying items less fulfilment cash flows that do not vary based on the returns on underlying items. [source] 

VFA-eligible contracts are contracts that disclose the determinable fee (which is displayed as a percentage of portfolio returns or asset values rather than as a monetary amount). Without a specified fee, the share of returns on the underlying items the insurer holds would be entirely at the discretion of the insurer, which goes against the purpose of IFRS 17. 

Initially, IFRS 17 was proposed to become effective on 1 January 2021. The Exposure Draft Amendments (ED/2019/4) issued in June 2019 acknowledged concerns about the standard and implementation challenges and concluded to defer its effective date by one year to 1 January 2022. 

The date was once again reconsidered. On 17 March 2020, the Board announced the new effective date for IFRS 17 would be 1 January 2023, two years after the initial proposal and 19 years after the release of its preceding standard. 

This begs the question, will IFRS 17 be delayed for the third time? It is also the subject of many recent debates. 

Summary of IFRS 17 development timeline 

• 25 June 2020: IASB issues amendments to IFRS 17 to support companies during the implementation of the Standard. The amendments also aim at helping companies to better explain their financial performance. 
• 17 March 2020: IASB announces the new effective date for IFRS 17 to be 1 January 2023.  
• 26 June 2019: IASB issues Exposure Draft Amendments (ED/2019/4) to propose amendments to IFRS 17 and a new effective date, 1 January 2022. The amendments aim at minimising disruptions to current implementation activities.  
• 18 May 2017: IASB issued IFRS 17, the first truly international reporting standard for insurance contracts that aimed at increasing consistency and transparency as well as providing policyholders with a better view into insurers’ risk exposure, profitability and financial position. The effective date was expected to start on or after 1 January 2021. 

Insurers shall apply the Standard to all insurance contracts unless otherwise impossible. This applies to: 

• All insurance contracts, including reinsurance. 
• Reinsurance contracts the insurer holds. 

• Investment contracts with discretionary participation features it issues, provide the insurer also issues insurance contracts. 

Contracts that are primarily used to outline the provision of services for a fee but meet the definition of an insurance contract: these types of contracts are still subject to IFRS 17 unless they choose to apply a different standard. 

Insurance contracts that may contain components that fit under the scope of another standard (e.g., an investment or service component): insurers need to follow the Standard’s criteria to determine whether a non-insurance component is distinct and carry out an assessment, following reporting requirements using the appropriate standard.  

To support insurers and others with the transition, the Board has established a Transition Resource Group, produced education materials, and actively sought to understand concerns and challenges that insurers have experienced while applying the new Standard. 

Fun fact: Where are IFRS adopted?

Source: Casualty Actuarial Society