QFIP-149: PWC - Inside Look at IFRS 17

Question 1

Describe desirable characteristics for the discount rate of liability cashflows under IFRS 17

Answer 1

• Reflect the cash flows and liquidity chraracteristics of the insurance contracts
  
  • For example, if liability cashflows vary with returns on the underlying items, then they should be discounted using discount rates reflecting that variability (i.e. the discount rate will have a spread)
  • However, if the cash flows do not have such variability and are essentially deterministic, a ’risk-free rate’ may be a more appropriate discount rate
• Be consistent with observable current market prices for financial instruments with cash flows that are consistent with those of insurance contracts
• Do not directly use asset-based discount rates if the asset returns do not affect the cash flows of the insurance contracts
  
  • However, asset returns held by the insurer could be used as a starting point to determine a permissible discount rate

Question 2

Describe situations that will lead to an increase of the risk-adjustment for non-financial risk under IFRS 17

Answer 2

• Risks with low frequency and high severity will result in higher risk adjustments
• For similar risks, contracts with a longer duration will result in higher risk adjustments
• Risks with a wider probability distribution will result in higher risk adjustments
• The less known about the current estimate of a non-financial risk factor and its trend, (i.e. mortality rates) the higher the risk adjustment

Question 3

Define onerous contract under IFRS 17

Answer 3

A group of contracts is onerous if total fulfillment cashflows at the date of inception are a net outflow, resulting in a negative contractual service margin.

• Under this case, the company basically has an expected loss on selling these onerous contracts
• It’s also possible for an insurance contract to become onerous later on when adjustment to the CSM exceeds the amount of the current CSM
• This excess will be recognized in profit or loss immediately

Question 4

Under IFRS 17, describe how the contractual service margin can be adjusted over a reporting period under the general model

Answer 4

• Adding new contracts to a group
• Accretion of interest on the CSM balance
• Changes in fulfillment cash flows and experience adjustments
  
  • Includes experience adjustments for differences between the estimate of the assumption at the beginning of the period, and actual payment during the period (for example, fewer contracts lapse than expected)
  • Changes in estimates of the present value of future cash flows in the liability for remaining coverage because of changes in key assumptions, such as mortality
  • Changes in the risk adjustment for non-financial risks that relate to future service
• Release of the contractual service margin to profit or loss
  
  • This should reflect services transferred to policyholders during the period based on coverage units

Question 5

Three Measurement Approaches under IFRS 17

Answer 5

There are three measurement approaches under IFRS 17 for different types of insurance contracts:

1. General model: Requires entities to measure an insurance contract at initial recognition at the total of the fulfullment cashflows and the contractual service margin
2. Premium allocation approach: Simplified approach that applies to contracts with a coverage period of one year or less
3. Variable fee approach: A variation of the general model where the entity’s share of the fair value changes of the underlying items is included in the contractual service margin

Question 6

Describe how the premium payments should be allocated to revenue by insurance companies who adopt the premium allocation approach under IFRS 17

Answer 6

Under the premium allocation approach, the insurer should allocate the expected premiums to P&L based on two options:

• The passage of time (i.e. amortize unearned revenue linearly as the coverage period is completed)
• On the basis of the expected timing of incurred insurance service expenses, if the expected pattern of release of risk is significantly different from the passage of time

Question 7

List a few types of insurance products that are direct participating insurance contracts that would qualify for the variable fee approach under IFRS 17

Answer 7

• Unit-linked contracts
• US variable annuities
• Certain equity index-linked contracts
• UK with profits contracts

Question 8

Describe the benefit of using the variable fee approach for direct participating contracts

Answer 8

The main idea of the variable fee approach is that fair value changes to the contract are not immediately recognized in P&L over the period in which they occur

• Instead, they get absorbed into the contractual service margin, and they will get released into P&L over the remaining life of the contract
• The main benefit of this approach is it allows the insurer to reduce income volatility from changes in the variable fee

Question 9

Describe differences in the measurement of the contractual service margin after initial recognition between the general model and the variable fee approach

Answer 9

1. Contract service margin for contracts with direct participation features is not explicitly adjusted for the accretion of interest
2. Insurance liabilities under the variable fee approach should be measured based on the change in the fair value of the underlying items
3. Effects on fulfillment cash flows of changes in financial risks not arising from the underlying items (such as the minimum return guarantee of the contract) will go into the CSM under VFA, but will go into the statement of OCI under the general model
4. Under VFA, adjustments to the CSM use current discount rates, while under the general model they use discount rates locked in at inception of a group of insurance contracts

Question 10

Describe a few criteria that causes a modified insurance contract to become derecognized

Answer 10

• The modified contract would have been excluded from the scope of IFRS 17 if the modified terms had already been included at inception of the contract
• The entity would have separated different components from the host insurance contract if the modified terms had already been included at inception of the contract
• The modified contract no longer meets the definition of an insurance contract with direct participation features, whereas the original contract did

Question 11

Describe the modifications that will be need to be performed on the liability calculation for a group of insurance contracts if a subset of the contracts become derecognized

Answer 11

• Present value of the future cash flows and the risk adjustment for non-financial risk that relate to the contract that is derecognized are eliminated
• The contractual service margin will be adjusted based on expected profitability of the new contract
• The number of coverage units for the expected remaining coverage is adjusted to reflect the coverage units extinguished from the derecognized contract

Question 12

Describe insurance revenue, and one method for calculating it under IFRS 17 for a reporting period

Answer 12

Insurance revenue reflects the premium payments the insurer expects to receive on its products.

One method for calculating it is to sum the changes in the liability for the remaining coverage in the period. In particular, we add the following components:

1. Insurance claims and expenses incurred in the period, based on the measured amount of expected claims/expenses at the beginning of the period
2. Changes in the risk adjustment for non-financial risk
   
   • It’s also permissible for the insurer to include a portion of this change in insurance finance income or expenses.
3. Amount of the contractual service margin recognized in P&L for the period

Question 13

Describe how insurance revenue recognition has changed under IFRS 17 compared with previous regulation

Answer 13

• Under old regulation, revenue was simply equal to the premium received during the period
• Under IFRS 17, revenue is now recognized under an accrual basis (instead of a cash basis), and will be recognized as services of the insurance contract are provided through the coverage period

Question 14

Desribe what insurance service expenses consist of under IFRS 17

Answer 14

• Incurred claims (i.e. the actual claims that occurred over the reporting period, which could be higher or lower than the expected claims)
• Amortization of insurance acquisition cash flows
• Changes relating to past services (changes in fulfillment cash flows relating to liabilities for incurred claims)
• Changes relating to future services (losses/reversals on onerous groups of contracts)

Question 15

Describe what is in the insurance finance income/expenses on the financial statement under IFRS 17

Answer 15

The insurance finance income / expenses reflect the changes in the carrying amount of insurance contracts that relate to financial risk. This consists of the following:

• The time value of money (i.e. accretion of interest on all fulfillment cashflows, non-financial risk adjustment, and CSM)
• The effect of changes in financial risk variables, such as interest rates, a commodity price, and equity index level, etc

Question 16

Describe a few disclosures that IFRS 17 requires insurers to make on their financial statements

Answer 16

IFRS 17 requires insurance companies to provide significantly more disclosures on their financial statements, including:

• Amounts recognized in financial statements
  
  • Includes reconciling the change in balance sheet items
• Significant judgments and changes in those judgments
  
  • Includes the methods that the insurer uses to measure insurance contracts, and how inputs to the model are estimated
• Nature and extent of risks
  
  • For each type of risk (i.e. insurance, market, credit, liquidity), the entity should disclose its exposure amount, how the exposure arises, and the policies and processes for managing the risk
  • Sensitivity analysis can be performed to show the impact changes in the risk variables can have on the entity’s P&L

Question 17

List three approaches companies can take when transitioning their insurance blocks to IFRS 17

Answer 17

• Retrospective approach
• Modified retrospective approach
• Fair value approach

Question 18

Explain why the retrospective approach can be impractical for the IFRS 17 transition for long-term insurance contracts that were issued a long time ago

Answer 18

The full retrospective approach is impractical for long-term insurance products issued a long time ago because:

• It would require assumptions about what management’s intent would have been at the time the policies were first sold
• It would require estimates of all the assumptions the company would have used (i.e. financial assumptions, mortality assumptions) when the policies were first issued

Question 19

Describe some simplifying assumptions insurers can make in the modified retrospective approach for transitioning to IFRS 17

Answer 19

• Assessments at the date of initial recognition of groups of insurance contracts
  
  • An entity is permitted to aggregate contracts into a group that have been issued more than one year apart
  • This allows entities to avoid grouping contracts according to the year they were issued, as often this type of information may not be available at this level of detail
• The risk adjustment is equal to the risk adjustment at the transition date, adjusted for expected release of risk before transition date
• Contractual service margin for insurance contracts without direct participation features
  
  • Future cash flows at the date of initial recognition of a group of insurance contracts can equal the future cashflows estimated at the transition, adjusted by actual cash flows that have occurred between the transition date and date of initial recognition
  • The discount rate to be applied at the date of initial recognition can be based on an observable yield curve (from the date of the transition) that approximates the yield curve required by IFRS 17

Question 20

Describe how the contractual service margin is calculated under the fair value approach for transitioning IFRS 17

Answer 20

• The contractual service margin is calculated as the difference between the fair value of a group of insurance contracts and its fulfillment cash flows at the transition date
• The fair value measurement of a liability is the value that a market participant would require in return for assuming all of the obligations related to that liability