Ladies and gentlemen, may I please introduce to you… IFRS 17, Insurance Contracts. We’ve been waiting for her a very long time and many even questioned whether she would ever come before us… but here she is in all her glory!

Last month, the IASB issued IFRS 17 after years and years of deliberating on how to improve or replace its predecessor, IFRS 4. For a training specialist like me, the replacement of IFRS 4 signifies an end to the easiest IFRS standard I ever got to teach. In fact, I would be able to do it in mere seconds. Don’t blink and I’ll teach it right now… IFRS 4 stated that whatever an entity currently was doing to account for insurance contracts… keep on doing it! While this may be a bit simplistic, it really isn’t that far from the principles of the standard. Therefore, a move to IFRS 17, a truly comprehensive principles-based insurance standard, will be a potentially significant one for insurers and one that will impact them in different ways, depending on how they were accounting for insurance contracts previously under IFRS 4.

IFRS 17 and its accounting for insurance contracts incorporates similar principles seen in recent standards such as IFRS 9 (financial instruments) and IFRS 15 (revenue recognition) in that it requires consistent and current measurement model, updated information about the obligations, risks and performance of insurance contracts, and increases transparency of financial information reported.

Why the Need for Change?

The challenge for accounting and reporting for insurance contracts has often come down to the fact that they come in so many different variations:

• Some are short term while others are long term and carry substantially different and unique risks
• They are generally “one-on-one” contracts and therefore not traded in markets or observable
• May incorporate investment elements that provide a payment by the insurance company, whether or not an insured event occurs

As a result of these challenges, differing accounting models have developed over the years depending on the types of insurance contracts. U.S. GAAP, for instance, has substantially different models for short-duration versus long-duration contracts. Aspects of the long-duration contract accounting model also differ depending on the specific attributes of the contracts. IFRS 17 offers one principles-based model of accounting for all insurance contracts.

The Balance Sheet Approach

IFRS 17 requires insurance contracts to be reported as an obligation on the balance based as the total of:

• Fulfilment cash flows – representing the present value of future cash flows based on the current estimates of amounts that the insurer expects to collect from premiums and claims related payments (e.g. benefits, expenses, etc.). Added to this amount is a “risk adjustment”, essentially representing the uncertainty surrounding the timing and risk of those cash flows (i.e. the riskier or more uncertain the timing and extent of the cash flows, the higher the risk adjustment). Of course, as these amounts represent the present value of future cash flows, discounting, at current rates, must also be taken into account
• Contractual service margin – representing the inherent profit remaining in the contract after consideration of the fulfillment cash flows. The contractual service margin is recognized over the remaining term of the insurance contract and therefore essentially represents “unearned profit”.

What makes IFRS 17 particularly challenging is the requirement to maintain current estimates of the fulfillment cash flows. Therefore, elements of variability inherent in the cash flows of these contracts must be continually reassessed, and consideration must be given to current market information and the current economic environment (e.g. changes in interest rates). These factors are required to be taken into account on a timely basis such that insurance obligations remain current and reporting is transparent.

Income Statement Impacts

On the income statement, IFRS 17 requires a company to distinguish its profits on insurance contracts between:

• Insurance services – representing the profit earned from providing insurance coverage (i.e. difference between premiums and benefits)
• Financial benefits – representing both the investment income earned from managing financial assets (i.e. purchased from cash inflows from insurance contracts) and finance expenses from insurance obligations (i.e. effects of discount rates and the time value of money)

Profits from insurance services are recognized over the period when insurance protection is provided (not when premiums are received!). Any changes in the profit as a result of changes in estimates is recognized as an adjustment to the contractual service margin (balance sheet) and recognized prospectively over the remaining coverage period. Of course, if at any time it is determined that the insurance contracts are loss making, the loss is recognized immediately in profit and loss. This revenue recognition approach is consistent with IFRS 15 principles as well as the way that many short-duration insurance contracts are accounted for today.

Stay Tuned

This high-level overview of IFRS 17 barely scratches the surface of the issues that insurers will be faced with as they look to implement the new standard. Luckily, they have some time. IFRS 17 is effective beginning in 2021, but the brave may early adopt as long as they also adopt IFRS 15 and IFRS 9 by that time. As with the other recent standards, experts are warning about the implementation issues beyond accounting and reporting, noting the IT and overall business and investor relations impacts that must be considered. In future blogs, we will undoubtedly dig deep to get to know our new friend, but in the meantime, let’s welcome IFRS 17 and the insurance contracts standard to the world!

Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.