Viewpoint: Level of aggregation under IFRS 4 Phase 2 insurance contracts

Level of aggregation under IFRS 4 Phase 2 for insurers

Although the concept of ‘level of aggregation’ may seem somewhat technical and esoteric, it is one of the key drivers of profit recognition in the new model under IFRS 4 Phase 2 insurance contracts.

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What is level of aggregation and why does it matter?

The term ‘level of aggregation’ has been used by the International Accounting Standards Board (IAIS) in its work on the forthcoming insurance contracts standard (‘the standard’) to describe the level at which an entity aggregates its contracts when applying the measurement and presentation principles. Different units of account may be used when applying different measurement and presentation principles. The extent to which contracts are aggregated may have a significant impact on the statement of comprehensive income of an insurance entity, and on its systems, processes and data.

What has the IASB decided?

When applying the standard, an entity will be permitted to aggregate contracts, provided that the approach would meet the objectives to measuring individual insurance contracts. At inception, entities will be permitted to group insurance contracts that have similar profitability and cash flows that respond in a similar way to key risk drivers for the following purposes: 

  • Recognizing losses for onerous contracts – a loss would be recognized only when the Contractual Service Margin (‘CSM’) is negative for the group of contracts.
  • Allocating the CSM - in addition to the similar profitability and cash flows requirements, contracts will also need to have coverage periods that are expected to end at a similar time. 

What are the implications of these decisions?

Reported results

If contracts are measured on an individual basis, losses on onerous contracts would be recognized immediately, but profits on profitable contracts would be recognized over their coverage period. In most of the current accounting frameworks this asymmetry between the accounting treatment of onerous and profitable contracts does not arise, either because there is no restriction on the recognition of profits at inception, or because insurance contracts are aggregated at a higher level and a loss would be recognized at inception only if the portfolio of contracts, as a whole, was onerous. 

If an entity is required to recognize losses on onerous contracts at inception when adopting the standard, but was previously able to offset those losses against expected profits on other contracts, this will cause a reduction in the entity’s equity on transition to the standard.

Systems and processes

The expected future cash flows and CSM can be measured on either:

  • An individual contract basis, using average assumptions for cash flows, or
  • an aggregated basis, where permitted.

Entities will need to balance the benefits of aggregating large volumes of policy data, to the extent possible, against the complexity of establishing and monitoring aggregation methodologies that will comply with the new standard. Some insurers may already have actuarial valuation systems that support or have the capability to support contract-by-contract approaches. Consequently, it may be easier for them to apply the new measurement requirements on in individual basis. However, some other insurers may currently undertake policy valuations at a portfolio level or at a level of aggregation that does not align to the proposed IASB requirements. This could mean significant system, data or valuation methodology change, in order to capture the different assumption on a granular level.

Actions to consider

Of course the IASB’s final decisions and guidance on ‘level of aggregation’ will only be known when the standard is published, insurance entities should start to consider how they might meet the considerable challenge of granularity of assumptions at the level required by the IASB, and to assess the possible impact on their reported results and systems. In particular, entities should:

  • Identify the product types that might require contracts to be separated into different groupings because they have different profitability and key risk drivers. For example, grouping by different profitability levels might be required for the same product as a result of the gender, age, illness history, smoking status etc. of the policyholders.
  • Undertake initial investigations into the availability of required data and functionality of existing systems, and identify the likely areas of biggest impact as a result of the aggregation approach adopted.
  • Identify contracts qualifying for mutualization.

IFRS – Insurance

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