IFRS 17 is so hot right now! I just got back from a week-long tour including Europe and Canada where we ran multiple offerings of our full day comprehensive course covering the new insurance contracts under IFRS. Fulfillment cash flows are at the center of this new standard’s general measurement model (or GMM) and learning what comprises these cash flows may surprise you. With an effective date of January 1, 2021 (for now), now is the time to begin to understand the details and challenges behind the new model for accounting for insurance contracts.

The standard’s base model for accounting for insurance contracts is the GMM. This approach is often referred to as the “Building Block Approach” (or BBA) as this was how it was referred to in exposure drafts during the project phase. The components of the model, or building blocks, include “fulfillment cash flows” and the “contract service margin” (or unearned profit) in the contract. Fulfillment cash flows consist of:

• Net future cash flows
• Discounting
• Explicit risk adjustment

Each component of the fulfillment cash flows represents a likely change from existing accounting practices for insurance contracts and will need to be carefully examined to ensure compliance with the new standard. In part 1 of this three-part blog, we will take a closer look at net future cash flows.

Net future cash flows represent an explicit, current, unbiased, and probability weighted estimate of the future cash outflows and inflows that will arise as the entity fulfills the insurance contract. This estimate, that captures net cash flows over the life of the insurance contract, is:

• Explicit: This means that the adjustment for non-financial risk is estimated separately from the other estimates. The adjustments for the time value of money and financial risk are also generally estimated separately from the cash flow estimates.
• Current: The estimates of future cash flows should reflect conditions existing at the measurement date, including assumptions at that date about the future, and should incorporate all reasonable and supportable information available without undue cost or effort about amount, timing, and uncertainty of those future cash flows.
• Unbiased: Estimates include the expected value of the full range of possible outcomes and be unbiased (that is, neither conservative nor optimistic).
• Probability-weighted: The expected value represents a probability-weighted mean of a range of scenarios that reflect the full range of possible outcomes. For each scenario, the entity should identify the amount, timing, and probability of that outcome. The approach to identify the most likely outcome or more-likely-than-not outcome does not comply with the requirements of IFRS 17.

The estimates of future cash flows should reflect the perspective of the entity, provided that the estimates of any relevant market variables are consistent with observable market prices for those variables. And only cash flows that are within the contract boundary of the insurance contract are to be included.

These cash flows will be incorporated into a single account line item, insurance contract liability, and include items such as:

• Premiums (including installment premiums)
• Premium adjustments (e.g. experience adjustments expected to be made in future)
• Claims payable on incurred losses
• Claims expected to be made on future losses
• Acquisition costs (i.e. underwriting costs)
• Claims related expenses (adjuster and legal fees, internal claims processing expenses, etc.)
• Among others

Many of these items were previously accounted for and recognized separately from other items, but now are incorporated into the same balance sheet line item. Estimates of net future cash flows are updated each reporting period as estimates and conditions change.

So, what is excluded from the net future cash flows? 

• The big one is investment returns, which means insurance strategies that accept underwriting losses and look to make up for the loss through strong investment profits, as was the case for many P&C insurers a few years back, run the risk of creating onerous insurance contracts. These onerous contracts require upfront loss recognition, despite future investment profits.
• Reinsurance contracts held (i.e. “ceded” reinsurance) is explicitly accounted for on a gross basis. This results in reinsurance cash flows being accounted for as a separate asset account, with the direct insurance contract recognized as a liability.
• Other cash flows not directly tied to the insurance contract or outside the boundary of the insurance contract.

While the concept of net future cash flows seems straight-forward enough, applying this concept may present more challenges that one might think. Estimates of these ‘explicit’ cash flows will generally be based on an insurance company’s historical information of its past insurance contracts. This means systems and data collection will be critical when applying the new standard. If an insurer’s own historical information is not available due to a new product or type of customer, industry data may be used, once again requiring access to data and information 

It only gets more challenging from here. When it comes to cash flows, the time is now to start gathering information to enable insurers to estimate their net future cash flows. In future blogs, we will further explore fulfillment cash flows under IFRS 17 and the challenges its poses for accounting for insurance contracts going forward.

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.