Insurance Contract modification and derecognition

Contract modification and derecognition – A contract that qualifies as an insurance contract remains so until all rights and obligations are extinguished (i.e., discharged, cancelled or expired) unless the contract is derecognised because of a contract modification [IFRS 17 B25]. Contract modification and derecognition

IFRS 4 contained no guidance on when or whether a modification of an insurance contract might cause derecognition of that contract. Therefore, prior to IFRS 17, most insurers would have applied the requirements, if any, contained in local GAAP. ConInsurance coveragetract modification and derecognition

1. Modifications of insurance contracts

An insurance contract may be modified, either by agreement between the parties or as result of regulation. If the terms are modified, an entity must derecognise the original insurance contract and recognise the modified contract as a new contract, if and only if, any of the conditions listed below are satisfied [IFRS 17 72]. Contract modification and derecognition

  • If the modified terms were included at contract inception: Contract modification and derecognition
    • The modified contract would have been excluded from the scope of IFRS 17. Contract modification and derecognition
    • An entity would have separated different components from the host insurance contract (see ‘Separation of insurance contracts‘) resulting in a different insurance contract to which IFRS 17 would have applied. Contract modification and derecognition
    • The modified contract would have had a substantially different contract boundary (see ‘Contract boundary‘). Contract modification and derecognition
    • The modified contract would have been included in a different group of contracts at initial recognition (e.g., the contracts would have been onerous at initial recognition rather than having no significant possibility of being onerous subsequently (see ‘Portfolio of insurance contracts‘). Contract modification and derecognition
  • The original contract met the definition of an insurance contract with direct participation features, but the modified contract no longer meets that definition or vice versa.
  • The entity applied the premium allocation approach (see  ‘Premium allocation approach‘) to the original contract, but the modifications mean that the contract no longer meets the eligibility criteria for that approach.

In summary, any contract modification that changes the accounting model or the applicable standard for measuring the components of the insurance contract, is likely to result in derecognition. The standard clarifies that the exercise of a right included in the terms of a contract is not a modification.

If a contract modification meets none of the conditions above for derecognition, the entity should treat any changes in cash flows caused by the modification as changes in the estimates of the fulfilment cash flows.

See Onerous contracts and Mitigating financial risks with derivatives for the accounting for changes in the fulfilment cash flows. Accounting for derecognition of a modified contract is discussed in 3 below.

Consideration

The guidance on contract modification and derecognition under IFRS 17 is likely to be different from current practices applied under IFRS 4. Entities should also consider whether changes to the terms and conditions of contracts prior to the transition date exist that would result in modification or derecognition of that contract. Such events could have a significant impact on the CSM on transition.

2. Derecognition of insurance contracts

An insurance contract is derecognised when, and only when [IFRS 17 74]:

  • It is extinguished, i.e., when the obligation specified in the insurance contract expires or is discharged or cancelled Contract modification and derecognition
    Or Contract modification and derecognition
  • Any of the conditions for modifications which result in derecognition are met (see 1) Contract modification and derecognition

When an insurance contract is extinguished, the entity is no longer at risk and not required to transfer economic resources to satisfy the contract. Therefore, the settlement of the last claim outstanding on a contract does not necessarily result in derecognition of the contract per se, although it may result in the remaining fulfilment cash flows under a contract being immaterial.

For derecognition to occur, all obligations must be discharged or cancelled. When an entity purchases reinsurance, it should derecognise the underlying insurance contracts only when those underlying insurance contracts are extinguished [IFRS 17 75].

3. Accounting for derecognition Contract modification and derecognition

There are three different ways to treat the derecognition of a contract, depending on the circumstances: extinguishment (see 3.1), transfer (see 3.2) or modification (see 3.3).

3.1. Derecognition resulting from extinguishment

Contract modification and derecognitionAn entity derecognises an insurance contract from within a group of insurance contracts by applying the following requirements [IFRS 17 76]:

  • Fulfilment cash flows allocated to the group for both the liability for remaining coverage and the liability for incurred claims are adjusted to eliminate the present value of the future cash flows and risk adjustment for non-financial risk relating to the rights and obligations that have been derecognised from the group.
  • The CSM of the group is adjusted for the change in fulfilment cash flows described above, to the extent required by the general model, as discussed in this section (for contracts without direct participation features) and this section (for contracts with direct participation features).
  • The number of coverage units for expected remaining coverage is adjusted to reflect the coverage units derecognised from the group, and the amount of the CSM recognised in profit or loss in the period is based on that adjusted number to reflect services provided in the period.

In practice, derecognition resulting from extinguishment will mostly occur on contracts where a CSM (or liability for remaining coverage) no longer exists. In these circumstances, extinguishment will result in the elimination of any fulfilment cash flows for the liability for incurred claims with a corresponding adjustment to profit or loss. An entity might not know whether a liability has been extinguished because claims are sometimes reported years after the end of the coverage period, and it may be unable to derecognise those liabilities.

In the IASB’s view, ignoring contractual obligations that remain in existence and may generate valid claims would not give a faithful representation of an entity’s financial position. However, when the entity has no information to suggest there are unasserted claims on a contract with an expired coverage period, it is expected that the entity would measure the insurance contract liability at a very low amount. Accordingly, there may be little practical difference between recognising an insurance liability measured at a very low amount and derecognising the liability [IFRS 17 BC322].

3.2. Derecognition resulting from transfer Contract modification and derecognition

When an entity derecognises an insurance contract because it transfers the contract to a third party, the entity must [IFRS 17 77]:

  • Adjust the fulfilment cash flows allocated to the group for the rights and obligations that have been derecognised, as discussed at 3.1.
  • Adjust the CSM of the group from which the contract has been derecognised for the difference between the change in the contractual cash flows resulting from derecognition and the premium charged by the third party (unless the decrease in fulfilment cash flows is allocated to the loss component of the liability for remaining coverage).

If there is no CSM to be adjusted, then the difference between the fulfilment cash flows derecognised and the premium charged by the third party is recognised in profit or loss.

In addition, when an entity derecognises an insurance contract because it transfers that contract to a third party:

  • It must reclassify to profit or loss any remaining amounts for the group (or contract) that were previously recognised in other comprehensive income as a result of its accounting policy choice to disaggregate the finance income or expenses of a group of insurance contracts. This means that the OCI balance remaining is released to profit and loss.
  • However, if an entity holds the underlying items and, accordingly, uses the current period book yield approach for contracts with direct participation features (see  ‘Disaggregating insurance finance result’), it must not make any reclassification to profit and loss of remaining amounts for the group (or contract) that were previously recognised in other comprehensive income [IFRS 17 91] Contract modification and derecognition

3.3. Derecognition resulting from modification Contract modification and derecognition

When an entity derecognises an insurance contract and recognises a new insurance contract as a result of a modification described in 1 above, the entity must [IFRS 17 77]:

  • Adjust the fulfilment cash flows allocated to the group relating to the rights and obligations that have been derecognised, as discussed in 3.1 above.
  • Adjust the CSM of the group, from which the contract has been derecognised for the difference between the change in the contractual cash flows resulting from derecognition and the hypothetical premium the entity would have charged, had it entered into a contract with terms equivalent to the new contract at the date of the contract modification, less any additional premium charged for the modification (unless the decrease in fulfilment cash flows is allocated to the loss component of the liability for remaining coverage).
  • Measure the new contract recognised, assuming that the entity received the hypothetical premium that it would have charged, had it entered into the modified contract at the date of the contract modification. Contract modification and derecognition

Example – Contract derecognition resulting from modification

An entity modifies an insurance contract issued such that the modified contract would have been included in a different group of contracts and, applying the guidance in IFRS 17, determines that the contract should be derecognised and replaced by a new contract. The original contract was part of a group of insurance contracts that was not onerous. The group of contracts that the modified contract joins is also not onerous.

At the date of modification, the fulfilment cash flows of the contract were CU100 and the additional premium received at that date for the contract modification is CU20. The entity estimates that a hypothetical premium that it would have charged had it entered into the modified contract at that date was CU112. The fulfilment cash flows of the newly recognised contract were CU105.

This gives rise to the following accounting entries: Contract modification and derecognition

(Amounts in CU) Contract modification and derecognition

DR

CR

Cash

20

Derecognition of fulfilment cash flows in the group from which the contract is derecognised

100

Adjustment to CSM of the group from which the modified contract is derecognised (20 + 100 — 112)

8

Recognition of fulfilment cash flows of modified contract

105

Adjustment to the CSM of the group that the modified contract joins (112 — 105)

7

When an entity derecognises an insurance contract due to a modification and recognises a new one, it should treat any remaining amounts for the group (or contract) that were previously recognised in other comprehensive income in the same way as described for derecognitions resulting from transfer (see 3.2). Contract modification and derecognition

Consideration

The guidance on contract modification and derecognition under IFRS 17 is likely to be different from current practices applied under IFRS 4. Entities should also consider whether changes to the terms and conditions of contracts prior to the transition date exist that would result in modification or derecognition of that contract. Such events could have a significant impact on the CSM on transition.

IFRS 17 does not explicitly provide guidance on derecognition and modification of contracts in a group to which the entity applies the premium allocation approach. Therefore it appears that the principles relating to groups of contracts accounted for under the general model would be applied by analogy. Contract modification and derecognition

4. Example disclosures

Significant accounting policies

E. Insurance and reinsurance contract

vi. Measurement – Contracts measured under the PAA

vii. Derecognition and contract modification Contract modification and derecognition
The Group derecognises a contract when it is extinguished – i.e. when the specified obligations in the contract expire or are discharged or cancelled. [IFRS 17 74(a)]

Something else -   Eligibility of premium allocation approach

The Group also derecognises a contract if its terms are modified in a way that would have changed the accounting for the contract significantly had the new terms always existed, in which case a new contract based on the modified terms is recognised. If a contract modification does not result in derecognition, then the Group treats the changes in cash flows caused by the modification as changes in estimates of fulfilment cash flows. [IFRS 17 72–73, IFRS 17 74(b)] Contract modification and derecognition

On the derecognition of a contract from within a group of contracts: Contract modification and derecognition

  • the fulfilment cash flows allocated to the group are adjusted to eliminate those that relate to the rights and obligations derecognised;
  • the CSM of the group is adjusted for the change in the fulfilment cash flows, except where such changes are allocated to a loss component; and
  • the number of coverage units for the expected remaining coverage is adjusted to reflect the coverage units derecognised from the group (see (viii)). [IFRS 17 76]

If a contract is derecognised because it is transferred to a third party, then the CSM is also adjusted for the premium charged by the third party, unless the group is onerous. [IFRS 17 77]

If a contract is derecognised because its terms are modified, then the CSM is also adjusted for the premium that would have been charged had the Group entered into a contract with the new contract’s terms at the date of modification, less any additional premium charged for the modification. The new contract recognised is measured assuming that, at the date of modification, the issuer received the premium that it would have charged less any additional premium charged for the modification. Contract modification and derecognition

ix. Contracts measured under the modified retrospective approach

When any of these modifications was used to determine the CSM (or the loss component) on initial recognition: CModification of contractual termsontract modification and derecognition

  • the amount of the CSM recognised in profit or loss before 1 January 2020 was determined by comparing the coverage units on initial recognition and the remaining coverage units at 1 January 2020; and [IFRS 17 C15(b)] Contract modification and derecognition
  • the amount allocated to the loss component before 1 January 2020 was determined using the proportion of the loss component relative to the total estimate of the present value of the future cash outflows plus the risk adjustment for non-financial risk on initial recognition. [IFRS 17 C16] Contract modification and derecognition

G. Financial assets and financial liabilities

iv. Derecognition and contract modification

Financial assets Contract modification and derecognition
The Group derecognises a financial asset when the contractual rights to the cash flows from the financial asset expire, or it transfers the rights to receive the contractual cash flows in a transaction in which substantially all of the risks and rewards of ownership of the financial asset are transferred or in which the Group neither transfers nor retains substantially all of the risks and rewards of ownership and it does not retain control of the financial asset. [IFRS 9 3.2.3–3.2.6] Contract modification and derecognition

On derecognition of a financial asset, the difference between the carrying amount at the date of derecognition and the consideration received (including any new asset obtained less any new liability assumed) is recognised in profit or loss. For debt investments at FVOCI and financial assets that had already been derecognised at 1 January 2021, the cumulative gain or loss previously recognised in OCI is reclassified from equity to profit or loss. The cumulative gain or loss on equity investments designated as at FVOCI is not reclassified to profit or loss. [IFRS 9 3.2.12, IFRS 9 5.7.10, IFRS 9 B5.7.1] Contract modification and derecognition

The Group enters into transactions whereby it transfers assets recognised in its statement of financial position, but retains either all or substantially all of the risks and rewards of the transferred assets. In these cases, the transferred assets are not derecognised. Examples of such transactions are securities lending and sale-and-repurchase transactions (see Note 5(E)(iii)). [IFRS 9 3.2.6(b)]

Something else -   Presentation and disclosure

In transactions in which the Group neither retains nor transfers substantially all of the risks and rewards of ownership of a financial asset and it retains control over the asset, the Group continues to recognise the asset to the extent of its continuing involvement, determined by the extent to which it is exposed to changes in the value of the transferred asset. [IFRS 9 3.2.6(c)(ii)]

If the terms of a financial asset are modified, then the Group evaluates whether the cash flows of the modified asset are substantially different. If the cash flows are substantially different, then the contractual rights to cash flows from the original financial asset are deemed to have expired. In this case, the original financial asset is derecognised and a new financial asset is recognised at fair value. [IFRS 9 B5.5.25] Contract modification and derecognition

If a financial asset measured at amortised cost is modified but not substantially, then the financial asset is not derecognised. If the asset had not been derecognised at 1 January 2021, then the Group recalculates the gross carrying amount of the financial asset by discounting the modified contractual cash flows at the original effective interest rate and recognises the resulting adjustment to the gross carrying amount as a modification gain or loss in profit or loss. If such a modification is carried out because of financial difficulties of the borrower (see (iii)), then the gain or loss is presented together with impairment losses; in other cases, it is presented as interest revenue. [IFRS 9 5.4.3] Contract modification and derecognition

There is no guidance in IFRS 9 on the line item in the statement of profit or loss and OCI in which gains or losses on the modification of financial assets should be presented. A modification gain or loss may not necessarily relate to impairment, because not all modifications are performed for credit risk reasons.

Accordingly, an entity exercises judgement to determine an appropriate presentation for the gain or loss.

It appears that if the modification is not related to financial difficulties of the borrower, then an entity may present the gain or loss from the modification in interest revenue. This is because the calculation of the modification gain or loss can be considered to be part of the application of the effective interest method.

Something else -   Combination of Insurance Contracts

Financial liabilities Contract modification and derecognition

The Group generally derecognises a financial liability when its contractual obligations expire or are discharged or cancelled. The Group also derecognises a financial liability when its terms are modified and the cash flows of the modified liability are substantially different, in which case a new financial liability based on the modified terms is recognised at fair value. [IFRS 9 3.3.1–3.3.2]

On derecognition of a financial liability, the difference between the carrying amount extinguished and the consideration paid (including any non-cash assets transferred or liabilities assumed) is recognised in profit or loss. [IFRS 9 3.3.3] Contract modification and derecognition

Notwithstanding the above, when, and only when, the Group repurchases its financial liability and includes it as an underlying item of direct participating contracts, the GrouBoundaryp may elect not to derecognise the financial liability. Instead, the Group may elect to continue to account for that instrument as a financial liability and to account for the repurchased instrument as if it were a financial asset and measure it at FVTPL. This election is irrevocable and is made on an instrument- by-instrument basis. [IFRS 9 3.3.5]

If a financial liability measured at amortised cost is modified but not substantially, then it is not derecognised. Contract modification and derecognition

  • For financial liabilities that had not been derecognised at 1 January 2021, the Group recalculates the amortised cost of the financial liability by discounting the modified contractual cash flows at the original effective interest rate and recognises any resulting adjustment to the amortised cost as a modification gain or loss in ‘other finance costs’ in profit or loss. Any costs and fees incurred adjust the carrying amount of the liability and are amortised over the remaining term of the modified liability.
  • For financial liabilities that had been derecognised at 1 January 2021, the Group recognised any difference in present value as an adjustment to the effective interest rate and amortised it over the remaining life of the modified financial liability, with no immediate gain or loss recognised. [IFRS 9 B3.3.6, IFRS 9 BC4.253]

Insurance finance income and expenses Contract modification and derecognition
Amounts presented in OCI are accumulated in the insurance finance reserve. If the Group derecognises a contract without direct participation features as a result of a transfer to a third party or a contract modification, then any remaining amounts of accumulated OCI for the contract are reclassified to profit or loss as a reclassification adjustment. [IFRS 17 91(a)]

Contract modification and derecognition

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