Financial accounting module 21: IFRS 17 Measurement principles
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Financial accounting module 21: IFRS 17 Measurement principles 1
IFRS 17 Measurement approaches 1
General measurement model 2
Future cash flows: market consistent, current, unbiased, explicit 3
Future service, current service, and past service 4
Changes in claim estimates 5
Changes in market interest rates 5
Insurance contract liability 6
Investment components 7
The final exam problems test the general measurement model; you are not responsible for the variable fee approach, investment components, or the end-notes in this posting (which cite the text of IFRS 17). This posting is introductory; it has only brief illustrations. The final exam problems for IFRS 17 are based on the postings which show full illustrations.
IFRS 17 Measurement approaches
IFRS 17 has three ways to measure insurance contracts:
● the general requirements in IFRS 17 (building block approach or general measurement approach)
● the premium allocation approach (a simplified method for certain short duration contracts)
● the variable fee approach (for contracts with direct participation features)
This section summarizes important features of the general measurement model and gives simple illustrations.
The premium allocation approach is a simplified model and requires few changes from current practices. It may be used (at the option of the insurer) if the coverage period of each contract in the group is one year or less. Many general insurance contracts, general reinsurance contracts, and group insurance contracts are likely to be measured by the premium allocation approach.
The variable fee approach is used for equity-linked policies, unit-linked policies, segregated fund policies, universal life policies, variable life policies, variable annuities, and similar contracts. The policyholder receives the fair value of the underlying assets, minus the insurer’s variable fee for the sum of administrative expenses, financial guarantees (such as guaranteed minimum death benefits and maturity benefits), risk adjustments for non-financial risk, and acquisition expenses.
The variable fee approach differs from the general measurement model in that
● For the general measurement model:
○ The fulfilment cash flows are the present value of future cash flows at risk-free discount rates (if the cash flows do not depend on the expected returns from underlying assets) or at the expected returns on the underlying assets.
○ The contractual service margin accretes interest each year at the risk-free discount rate determined at initial recognition.
○ The insurance finance income or expense is the change in the value of the fulfilment cash flows and of the contractual service margin from the time value of money and changes in discount rates.
● For the variable fee approach:
○ The fulfilment cash flows are the underlying assets minus the insurer’s variable fee.
○ Changes in the insurer’s share of the underlying assets take the place of accretion of interest on the contractual service margin.
○ The insurance finance income or expense is the change in the fair value of the underlying assets.
Most other elements of the variable fee approach are like those of the general measurement model.
General measurement model
This section reviews the principles of the general measurement model; numerical illustrations are provided in other postings. The general requirements in IFRS 17 (the general measurement model or the building block approach) builds the insurance contract liability from four parts:
● a probability distribution of future cash flows
● discount rates for the time value of money and financial risk
● a risk adjustment for non-financial risk
● a contractual service margin reflecting the unearned profit in the insurance contracts
The first three items above form the fulfilment cash flows.
The fulfilment cash flows are a risk adjusted present value of the future cash flows:
● the mean of the probability distribution of future cash flows
● brought to present value (adjusted for the time value of money)
● plus a risk adjustment for non-financial risk.
The fulfilment cash flows do not include the contractual service margin, which reflects the unearned profit in the insurance contract, not the cash flows for claims and expenses.
The insurance contract liability equals the fulfilment cash flows plus the contractual service margin. IFRS 17 refers to the insurance contract liability as the carrying amount of the liability or the carrying amount of the insurance contracts, consisting of two parts: the liability for remaining coverage and the liability for incurred claims.
IFRS 17 paragraph 32 says (sentences re-ordered for clarity):
On initial recognition, an entity shall measure a group of insurance contracts at the total of:
(a) the fulfilment cash flows …
(b) the contractual service margin.
… the fulfilment cash flows … comprise:
(i) estimates of future cash flows …
(ii) an adjustment to reflect the time value of money and financial risks related to the future cash flows … (iii) a risk adjustment for non-financial risk …
The liability for remaining coverage is the liability for claims that have not yet occurred; the liability for incurred claims is the liability for claims that have already occurred.
The “adjustment to reflect the time value of money and financial risks” is the discount rate to convert nominal values to present values.
● The discount rate reflects the time value of money and financial risks.
● Changes in the discount rate reflect changes in financial assumptions.
The effect of the discount rate is insurance finance income or expense that is recognized in profit or loss each year. The effect of change in the discount rate is insurance finance income or expense that is recognized in profit or loss or in other comprehensive income, depending on the accounting policy choices of the insurer.
IFRS 17 requires insurance expenses to be divided between
● insurance finance income or expense: the change in the present value of future cash flows (part of the fulfilment cash flows) for the time value of money and changes in the discount rate, and the accretion of interest on the contractual service margin (the unearned profit in the insurance contracts).
● insurance service expense: the occurrence of claims and other expenses, such as acquisition expenses and claim adjusting expenses.
Illustration: On January 1, 20X1, the present value of future cash flows is 100, the contractual service margin is 15, and the discount rate is 6% and does not change in 20X1. A claim of 40 occurs on December 31, 20X1, and the amortized acquisition expenses in 20X1 are 10.
● The insurance finance expense can be computed as the accretion of interest (since the discount rate does not change), or 6% × (100 + 15) = 6.90.
● The insurance service expenses are 40 + 10 = 50.
The amortized acquisition expenses are not the same as the acquisition cash flows. If the coverage period for this illustration is one year and
● If the acquisition cash flows are paid at the end of the year (December 31, 20X1), the insurance service expenses are 40 + 10 = 50.
● If the acquisition cash flows are paid at the beginning of the year (January 1, 20X1) and amortized to the end of the year, the insurance service expenses are 40 + 10 × 1.06 = 50.60.
Future cash flows: market consistent, current, unbiased, explicit
The fulfilment cash flows include the present value of future cash flows. The estimates of future cash flows should be current, unbiased, and explicit. Non-market variables should reflect the perspective of the insurer; market variables should be consistent with market values.
Market consistent: Market variables, such as discount rates and the expected returns on specified pools of assets, must be consistent with current market data. The yield curve for insurance cash flows, the liquidity adjustments for these cash flows, and the effects of maturity on the yields should be supported by observed market prices. Mortality rates, accident frequencies, accident severities, and other underwriting estimates are not observed in active markets and are based on the insurer’s perspective, not on market values.
IFRS 17 allows several methods to compute discount rates, such as bottom-up or top-down methods. The risk-free interest rates for a bottom-up method may be derived from government bonds, credit default swaps, or other market values. The reference portfolio for a top-down method may be the insurer’s own investment portfolio, expected bond yields, or other market indices. But given the chosen method, the insurer’s estimate must be consistent with market data.
Insurer’s perspective: Estimates of non-market variables, such as mortality rates, morbidity rates, lapse rates, accident frequency, accident severity, mortality improvement, and trend rates, should reflect the insurer’s perspective, not that of market participants. Interest rates and inflation rates are correlated, so claim inflation rates should be consistent with market interest rates, even if they are not themselves market variables. Insurers project future cash flows from both internal experience and national data compilations (mortality tables). The internal experience is generally more detailed, with claim frequency refined by attributes of the policyholder, such as medical history, education, credit rating, and parents’ ages at death. National data compilations are often more credible, particularly for small insurers or small risk classifications. But insurers using industry data (mortality tables or rating bureau statistics) often adjust them for their own underwriting characteristics, accident trends, and mortality improvement.
IFRS 13, Fair Value Measurement, uses the perspective of market participants, not the perspective of the reporting entity. Fair value is the market value, not the value to the reporting entity. The IFRS 17 measurement approach is not a fair value model. IFRS 17, Basis for Conclusions, paragraph BC17, explains that
The Board developed this approach rather than a fair value model. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date… Such an approach places too much emphasis on hypothetical transactions that rarely happen. Therefore, IFRS 17 requires an entity to measure insurance contracts in a way that reflects the fact that entities generally fulfil insurance contracts directly over time by providing services to policyholders, rather than by transferring the contracts to a third party.
IFRS 17 does not apply the term fair value to insurance contracts or insurance claims, since these contracts and claims are not traded and the unearned profit on insurance contracts is not recognized until it is earned. The fair value of future claims is unknown, as no market for the claims exists. Rather, IFRS 17 combines a fair value-type model for the fulfilment cash flows based on the insurer’s best estimates (for claims and the risk adjustment for non-financial risk) and market consistent figures for market variables (like discount rates). The contractual service margin defers income until insurance services are provided, so investors see the insurer’s estimate of unearned profit at initial recognition on the statement of financial position but the statement of profit or loss shows only the earned profit.
Current: Assumptions for mortality, morbidity, lapses, accident frequency, average severity, loss cost trends, and similar items are updated at each valuation date using current data. Changes in assumptions, such as estimates of future cash flows or of current interest rates, affect the fulfilment cash flows. Current assumptions include estimates of future changes, such as mortality improvement for life insurance contracts and future loss cost trends for general insurance contracts.
Future service, current service, and past service
Changes in the fulfilment cash flows may relate to future service, current service, or past service:
● Changes in the fulfilment cash flows relating to claims that have not yet occurred (future services) are offset by opposite changes in the contractual service margin and do not directly affect profit or loss (unless the contracts are onerous). The fulfilment cash flows relating to future service plus the contractual service margin is the liability for remaining coverage.
● Changes in the fulfilment cash flows relating to claims that occur in the current year (current services) or that occurred in past years (past services) are recognized immediately in profit or loss; they are not offset by changes in the contractual service margin. The fulfilment cash flows relating to past service and current service is the liability for incurred claims.
The discount rate is the current (market) rate, the rate determined at initial recognition, or the rate determined when the claim occurs:
● The discount rate for future cash flows is the current market rate; it is not locked in at initial recognition. The current discount rate applies to all claims for the general measurement model and to incurred claims for the premium allocation approach.
● The discount rate for accretion of interest on the contractual service margin is the rate determined at initial recognition of the insurance contracts, not the current discount rate. The discount rate for the present value of changes in future cash flows affecting the contractual service margin is also the discount rate determined at initial recognition, not the current discount rate used for the fulfilment cash flows, so the change in the contractual service margin may not exactly offset the change in the fulfilment cash flows.
● The discount rate for future claims (liability for remaining coverage) for the premium allocation approach is the rate determined at initial recognition.
Changes in claim estimates
Illustration: On December 31, 20X1, an insurance contract that is not onerous has
● one claim that occurred in 20X1 for an expected payment of 100
● one claim expected to occur in 20X2 for a payment of 100
● one claim expected to occur in 20X3 for a payment of 100
On December 31, 20X2, the 20X2 claim occurs and is paid for 80. The insurer revises the expected payment of the 20X1 claim to 80 and of the 20X3 claim to 80. For simplicity, the discount rate is 0% per annum.
● The change for the 20X1 claim relates to past service (the liability for incurred claims) and is reported as profit of 100 – 80 = 20 in the statement of profit or loss.
● The change for the 20X2 claim relates to current service (an experience adjustment) and is reported as profit of 100 – 80 = 20 in the statement of profit or loss.
● The change for the 20X3 claim relates to future service (the liability for remaining coverage) and is reported as a reduction of 100 – 80 = 20 in the fulfilment cash flows and as an increase of 100 – 80 = 20 in the contractual service margin, with no direct effect on the statement of profit or loss. However, the increase in the contractual service margin causes a higher allocation of the contractual service margin to 20X2 (as well as to subsequent years). If the coverage period has four years remaining after December 31, 20X2, with equal coverage units in each year, the 20X2 profit or loss increases by 20 / (4 + 1) = 4.
The effects of a change in each claim from 100 to 120 are similar. For past service and current service, the insurer reports a loss of 20 in the statement of profit or loss. For future service, if the insurance contracts do not become onerous, the fulfilment cash flows increase 20, the contractual service margin decreases 20, and the allocation of the contractual service margin to profit or loss for 20X2 decreases 20 / (4 + 1) = 5. If the insurance contracts become onerous, the fulfilment cash flows increase 20, the contractual service margin decreases to zero, and the remaining increase in the fulfilment cash flows is reported as a loss in profit or loss.
Changes in market interest rates
Changes in market interest rates cause insurance finance income or expense for insurance contracts in-force and for unpaid claims. The insurer has a accounting policy choice whether to recognize all insurance finance income or expense in profit or loss or to dis-aggregate the insurance finance income or expense between profit or loss and other comprehensive income. The discount rate to determine the expense recognized in profit or loss if the insurer chooses to dis-aggregate insurance finance income or expense between profit or loss and other comprehensive income is
● the rate determined at initial recognition for insurance contracts using the general measurement model and for which investment yields do not materially affect the payments to policyholders
● the rate determined when the claim occurs for incurred claims under the premium allocation approach.
For insurance contracts using the general measurement model and for which the returns on specified pools of assets substantially affect the payments to policyholders, an insurer that dis-aggregates insurance finance income or expense between profit or loss and other comprehensive income uses the constant rate method or the projected crediting rate approach to determine the expense recognized in profit or loss.
Illustration: Insurance contracts issued on January 1, 20X1, have expected claims of 100 on December 31, 20X3. The discount rate is 6% at initial recognition and 5% at December 31, 20X1. The present value of future cash flows is 100 / 1.063 = 83.96 on January 1, 20X1, and 100 / 1.052 = 90.70 on December 31, 20X1, so the insurance finance expense for 20X1 is 100 × (1.05-2 – 1.06-3) = 6.74 = 90.70 – 83.96. If the insurer chooses to dis-aggregate the insurance finance expense between profit or loss and other comprehensive income, the 20X1 profit or loss for this expense is -6% × 83.96 = -5.04 (or 100 × (1.06-3 – 1.06-2) = -5.04) and the other comprehensive income for 20X1 is -6.72 – -5.04 = -1.68.
Unbiased: The estimate of future cash flows is the mean of the probability distribution; conservative estimates and ranges of estimates are not used. IFRS 17 has no provisions for adverse deviation; all estimates are the means of the probability distributions. Unbiased estimates are neither conservative nor optimistic.
Illustration: Suppose the future cash flows are uncertain, with present values of
● the most likely value = 100
● the median = 110
● the probability weighted mean = 125
The insurer is risk averse and values the uncertain future cash flows like a fixed cash flow with a present value of 135. The estimated future cash flow is 125, and the risk adjustment for non-financial risk is 135 – 125 = 10.
Explicit: Insurers should explicitly estimate the probability distribution of future cash flows, the term structure of interest rates appropriate for the insurance contract cash flows, and the risk adjustment for non-financial risk. They may not use conservative claim estimates or a lower discount rate in lieu of the risk adjustment for non-financial risk, as is done in some other accounting systems.
Insurance contract liability
At initial recognition, the insurer sets up for each group of insurance contracts:
● liabilities (reserves) for the future claim payments (future cash outflows)
● the risk adjustment for non-financial risk
● the contractual service margin
The reserves for future claim payments + the risk adjustment for non-financial risk + the contractual service margin = the insurance contract liability. The insurance contract liability combines policy reserves, claim reserves, premium reserves, the risk adjustment for non-financial risk, and the contractual service margin. The technical reserves (as used in Solvency II) are the present value of the future claim payments, to which a (fair value) cost of capital risk margin is added.
The insurance contract liability decreases each year for insurance services provided, release of risk margins, and allocation of the contractual service margin to profit or loss. If the insurance contracts are onerous, the liability for remaining coverage is divided between the liability for remaining coverage excluding the loss component and the loss component of the liability for remaining coverage.
Insurers collect premiums before paying claims. After the premium is received, they have net liabilities for expected claims, expenses, and benefits. Long-term life insurance contracts with initial premiums below the acquisition cash flows may have a net asset the first year. IFRS 17 paragraph 40 divides the insurance contract liability into:
● The liability for remaining coverage is the part of the insurance contract liability for claims that have not yet occurred (coverage that has not yet been provided), comprising
○ Future cash outflows for claims (and other expenses) that have not yet occurred
○ A risk adjustment for non-financial risk related to these claims
○ The contractual service margin
● The liability for incurred claims is the part of the insurance contract liability for claims that have occurred (coverage has been provided) even if they have not yet been paid, comprising
○ Future cash outflows for claims (and other expenses) that have already occurred
○ A risk adjustment for non-financial risk related to these claims
The liability for incurred claims has no contractual service margin. Insurance services are provided during the coverage period, not the claim settlement period. The profit embedded in the insurance contract is earned over the coverage period, so the unearned profit is zero at the end of the coverage period.
Investment components
Some payments to policyholders do not depend on the occurrence of an insured event, such as a death or an accident. An “investment component” is an amount that the insurer must pay a policyholder even if an insured event does not occur, such as maturity benefits on an endowment or withdrawals from permanent life insurance account balances.
Distinct investment components are separated from the insurance contracts and are reported in accordance with IFRS 9 (financial investments), not IFRS 17. An investment component is “distinct” if it is not highly inter-related with the insurance component. The two components are highly inter-related is the insurer measures one component only by considering the other or if the benefits from one component depend on the presence of the other component.
Illustration: An insurer provides both permanent life insurance and investment management services. If the insurance services and the investment management services are not related, even though they are in the same contract, they are accounted for separately.
Most investment components provided to policyholders are highly inter-related with the insurance contracts. Maturity values depend on the policyholder account balances after deduction for the cost of insurance in the insurer’s annual fee. These investment components are not separated from the insurance contracts and are accounted for under IFRS 17, but they are not insurance revenue or insurance service expenses.
The present value of the investment component is part of the insurance contract liability until the claim occurs or the investment component is paid, and the change in the present value of the investment component for the time value of money is included in the insurance finance expense. The investment component is determined when the claim occurs as the amount that would have been paid even if the insured event did not occur. Present values of investment components are not estimated at initial recognition or when premium is received.
End-notes: