IFRS 17 – Measuring insurance cash flows | KPMG | GLOBAL
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Measuring insurance cash flows

Measuring insurance cash flows

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Key observation

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IFRS 17 allows an insurer to use a reference portfolio to determine the discount rates used to measure insurance contracts. An insurer may choose to use its own assets as the reference portfolio, raising questions around the impact of changes to the asset mix on the discount rate and highlighting the importance of disclosures to financial statement users.

Determining discount rates using a top-down approach

September 2018 TRG meeting

What's the issue?

An insurer may determine the discount rates used to measure insurance contracts by basing its calculations on a yield curve reflecting the current market rates of return of a reference portfolio of assets (i.e. using a top-down approach). 

In doing so, the insurer needs to adjust the yield curve to eliminate any characteristics of the assets that are not present in the insurance contracts – e.g. credit risk. However, it does not need to adjust for liquidity differences.

A question that arises is whether an insurer can use its own assets as the reference portfolio and, if so, whether changes in those assets should result in changes in the discount rates used to measure insurance contracts if it does not adjust for liquidity differences.

 

What did the TRG discuss?

TRG members observed that IFRS 17 does not impose any restrictions on the reference portfolio –therefore, it could be a portfolio of assets held by the insurer, as long as the discount rates achieve the objectives of:

  • reflecting the characteristics of the insurance contracts; and
  • consistency with observable current market prices. 

If an insurer uses its own assets as the reference portfolio and – as IFRS 17 permits – does not adjust for liquidity differences, then the changes in the portfolio’s liquidity would be reflected in the changes in the discount rates used to measure the related insurance contracts, even if the liquidity characteristics of the insurance contracts themselves have not changed. 

Insurers are required to adjust the yield curve of the reference portfolio to eliminate factors (other than liquidity differences) that are irrelevant to insurance contracts – e.g. credit risk changes. Therefore, changes related to credit risk would not impact the discount rate used to measure insurance contracts. 

 

What's the impact?

Insurers will generally endeavour to match assets and liabilities closely, so a reference portfolio based on own assets might be expected to reflect a level of liquidity as similar as possible to that of its issued insurance contracts. 

However, some differences will still arise and changes in the liquidity of the reference portfolio would flow through to the measurement of insurance contract liabilities if no adjustment is made for differences in liquidity. This would be the case if a greater proportion of illiquid assets are held – the measurement would reflect greater availability of illiquid investments in the market even though the liquidity characteristics of the insurance contract liabilities have not changed. 

To enable financial statement users to compare different insurers, it is essential that IFRS 17’s disclosure requirements are applied, particularly in terms of how the insurer:

  • identifies a reference portfolio; and
  • adjusts the yield curve to determine the discount rates, including whether it adjusts for liquidity differences. 

Under IFRS 17, entities are required to disclose significant judgements and changes in those judgements, including with respect to discount rates. Disclosing the effects of changes in the assets in the reference portfolio on the discount rates would provide useful information about the sources of changes to the insurance contract liabilities. 

 

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Accounting for the risk adjustment in industry pools managed by an association

September 2018 TRG meeting

What's the issue?

In some jurisdictions, all insurers issuing automobile insurance contracts are legally required to be members of a particular association, whose purpose is to provide insurance coverage to policyholders who would otherwise be unable to obtain it. This arrangement includes two types of industry pools.

Pool 1 Pool 2
Some members are appointed to issue contracts that belong to the industry pool on behalf of all members  Members can choose to transfer some insurance contracts they have issued
to the industry pool


The results of each industry pool are allocated to all of the members of the association based on a sharing formula. Under current practice, the share of the results is included in each insurer’s own financial statements as direct business.

A question arises over how members should account for their share in the results of the industry pool, and whether the risk adjustment for non-financial risk related to contracts in industry pools should be determined at the association level or the individual member level.

 

What did the TRG discuss?

The terms of a contract need to be analysed to identify the substance of the rights and obligations under the contract and who the issuer is. Facts and circumstances may indicate that contracts in an industry pool are considered to be issued by all members together.

As IFRS 17 provides no specific guidance on contracts with more than one issuer, insurers may need to consider whether other standards apply – including IFRS 11 Joint Arrangements – to determine how to reflect their share in the results of industry pools in their financial statements.

The risk adjustment that an insurer requires for non-financial risk reflects the compensation it would require for bearing that risk. Therefore, the risk adjustment reflects the degree of diversification benefits an insurer includes when making this determination.

TRG members observed that issuing a contract within an industry pool arrangement may affect these diversification benefits and, therefore, the risk adjustment.TRG members noted the differing views expressed as to whether the risk adjustment applied to the same group of insurance contracts could differ depending on the reporting level within a group of entities (see Determining the risk adjustment for individual and group reporting purposes).

 

What's the impact?

Industry pool arrangements are common in many jurisdictions. However, the diverse legal and contractual forms these take will require careful analysis in order to account for them appropriately. It is important to evaluate all relevant facts and circumstances of each arrangement to determine:

  • who the issuer of the contracts is;
  • how each member should account for its share in the pool; and 
  • how the risk adjustment for non-financial risk reflects the substance of the arrangements.  

 

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Determining the risk adjustment for individual and group reporting purposes

May 2018 TRG meeting

What's the issue?

The objective of the risk adjustment for non-financial risk is to reflect the entity’s perception of the economic burden of the non-financial risk that it bears. Therefore, the risk adjustment for an entity reflects the degree of diversification benefit that it includes when determining the compensation it requires for bearing that risk. 

The question that arises is whether an entity or its group can consider diversification benefits beyond the single entity – e.g. those available at the consolidated group level – when determining the risk adjustment.

 

What did the TRG discuss?

TRG members observed that when determining the risk adjustment, the entity that issues the contracts considers benefits of diversification that occur at a level higher than the entity if, and only if, they have been included when determining the compensation that the issuing entity requires for bearing non-financial risk. This compensation could be evidenced by the capital allocation in a group of entities.

For the purposes of group reporting, two methods were discussed.

The staff and some TRG members believed that determining the risk adjustment involves a single decision made by the entity that issues the contracts. Therefore, the risk adjustment at the consolidated group level should be the same as the risk adjustment at the individual issuing-entity level.

Other TRG members believed that the risk adjustment is based on an entity’s perception of the economic burden of the non-financial risk that it bears, and an individual entity within a group may have a different perception of non-financial risks from that of the consolidated group. This could result in different risk adjustments being applied for the same group of insurance contracts depending on the reporting level. 

TRG members noted that the method selected by a group of entities should be applied consistently across all groups of insurance contracts.

 

What's the impact?

Insurers may want to use the same risk adjustment at the consolidated group level and at the individual issuing-entity level for the same group of contracts. This may be operationally simpler than determining multiple risk adjustments for measurement purposes – one at the level of the individual entity that issued the contracts and another at the consolidated group level. 

IFRS 17 is principles-based and does not prescribe how to determine the risk adjustment. However, insurers applying IFRS 17 may need to look at:

  • how they price business;
  • how capital is allocated and target returns are determined; and
  • whether issuing entities operate within a group-wide risk appetite and risk management framework that reflects the benefits of group-wide risk diversification.  

 

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Insurance acquisition cash flows paid when contracts are issued

February 2018 TRG meeting

What's the issue?

Insurers may unconditionally pay insurance acquisition cash flows – e.g. commissions paid to sales agents – for contracts initially written with the expectation that they will be renewed. Sometimes these acquisition cash flows paid exceed the initial premium charged for the contract.

The insurer generally expects to recover these costs from future renewals. However, if those cash flows are outside the contracts’ boundaries, then they cannot be included when measuring the initially written contracts under IFRS 17.

This raises the question of whether future premiums can be allocated to insurance acquisition cash flows that are unconditionally paid when the contract is issued, if they are partly associated with future renewals.

 

What did the TRG discuss?

TRG members appeared to agree that any insurance acquisition cash flows that are:

  • directly attributable to individual contracts; and
  • unconditionally paid on initially written contracts,

should be included in the measurement of the group containing those contracts. Because the costs are paid unconditionally for each initially written contract, they cannot be allocated to future groups recognised on renewal or other groups that do not contain these contracts.

Various TRG members believed that the accounting outcome would not reflect the economic substance of the contract because it would not reflect the insurer’s long-term expectations.

The TRG members observed that if the facts and circumstances were different, then the outcome could be different. For example, if the insurance acquisition cash flows were not paid unconditionally, then it might be appropriate to allocate a part to future renewals.

 

What's the impact?

If a part of the insurance acquisition cash flows cannot be allocated to future renewals, then these types of contracts are more likely to be considered onerous on initial recognition. This is because the entire insurance acquisition cash flow would be reflected in the measurement of the initially written contracts.

When these cash flows result in an onerous contract on initial recognition, it will be in a group of contracts that are onerous at initial recognition. Therefore, contracts within the portfolio that are renewed, and that are expected to be profitable, would not be included within the same group. 

When these cash flows result in an onerous contract on initial recognition, it will be in a group of contracts that are onerous onat initial recognition. Therefore, contracts within the portfolio that are renewed, and that are expected to be profitable, would not be included within the same group. 

Some insurers currently use cost allocation techniques to allocate some insurance acquisition cash flows. These techniques may need to be reviewed and potentially adapted to reflect the approach described above. Insurers may also consider adjusting their terms and conditions for commission payments to make them conditional on future renewals.

 

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About this page

This topic page is part of our Insurance – Transition to IFRS 17 series, which covers the discussions of the IASB's Transition Resource Group (TRG) for Insurance Contracts.

You can also find more insight and analysis on the new insurance contracts standard at kpmg.com/ifrs17.

 

 

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