Direct participating contracts – Many insurers issue contracts under IFRS 17 that include features that share returns on underlying items with the policyholder(s). However, IFRS 17 draws a distinction between contracts with direct participation features (‘direct participating contracts’) and other participating and non-participating insurance contracts (‘contracts without direct participation features’), which is reflected in how the measurement model is applied in subsequent periods.
The distinction, and therefore the definition of direct participating contracts, assumes that significant investment-related service(s) are included in the contract when an entity promises an investment return based on underlying items. The underlying items can comprise any items as long as they are clearly identified by the contract.
When these services are substantial, the contract meets the definition of a direct participating contract and so the accounting reflects the notion that changes in the investment-related fees are considered to relate to future service. When a contract meets the requirements to be defined as a direct participating contract, it applies the modifications to the general measurement model discussed throughout this chapter. This approach is called the ‘variable fee approach’, because the CSM is adjusted to reflect the variable nature of the fee.
When the investment-related service(s) are not sufficiently substantial and the contract fails to meet the definition of a direct participating contract, any changes relating to these fees are recognised according to the general measurement model without any modifications.
The following table shows the primary measurement differences between the general measurement model and the variable fee approach
Direct participating contracts create an obligation to pay the policyholder an amount equal to the fair value of the underlying items, less a variable fee for future service. The variable fee comprises the entity’s share in the fair value of the underlying items less fulfilment cash flows – e.g. amounts payable to the policyholder – that do not vary based on the underlying items.
An insurance contract is considered to be a direct participating contract when:
- the contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items;
- the entity expects to pay the policyholder an amount equal to a substantial share of the fair value returns on the underlying items; and
- the entity expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in the fair value of the underlying items.
An entity assesses whether these conditions are met based on its expectations at inception of the contract, and this is not reassessed subsequently unless the contract is modified.
The contractual terms
As stated above, the contractual terms have to specify that the policyholder participates in a share of a clearly identified pool of underlying items. This does not preclude the existence of the entity’s discretion to vary the amounts paid to the policyholder. However, the link to the underlying items has to be enforceable, and enforceability is a matter of law.[ IFRS 17.B105]
|IFRS 17 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. When applying IFRS 17, entities should consider their substantive rights and obligations, whether they arise from contract, law or regulation. Therefore, when referring to contractual terms the effects of law or regulation are also considered.
For a contract to be considered a direct participating contract, it needs to specify the link to the underlying items, and this link needs to be enforceable by law.
These requirements are consistent with those in IFRS 15 and are applied when an entity considers how to classify a contract, and when assessing the boundary of a contract.
The agreement between two parties does not need to be in writing to be a contract. Whether the agreed-on terms are written, oral or otherwise evidenced – e.g. by electronic assent – a contract exists if the agreement creates rights and obligations that are enforceable against the parties. Determining whether a contractual right or obligation is enforceable is a question to be considered in the context of the relevant legal framework that exists to ensure that the parties’ rights and obligations are upheld.
Similar types of contracts issued in different jurisdictions might give a different answer in terms of there being a link that is enforceable by law. The practices and processes for establishing contracts with customers vary across legal jurisdictions, industries and entities and may vary within an entity, with different customers. An analysis of each different type of contract is essential to determine if each specifies an enforceable link to underlying items.
Clearly identified pool of underlying items
The contractual terms should specify a determinable fee that can be expressed as a percentage of portfolio returns or portfolio asset values. This means that the contract specifies that the policyholder participates in a share of a clearly identified pool of underlying items. The pool of underlying items can comprise any items as long as they are clearly identified in the contract. For example, the pool of underlying items may include reference to a portfolio of assets, the net assets of the entity or a subsidiary within the group that is the reporting entity, or a specified subset of net assets of the entity. An entity is not required to hold the identified pool of underlying items. [IFRS 17.B101, B106, BC245]
A clearly identified pool of underlying items does not exist when:
- an entity can change the underlying items that determine the amount of the entity’s obligation with retrospective effect; or
- there are no underlying items identified, even if the policyholder could be provided with a return that generally reflects the entity’s overall performance and expectations, or the performance expectations of a subset of assets that the entity holds.
|Link to clearly identified pool of underlying items
Entity B issues two different types of life insurance contracts that provide death benefits for the whole life of the policyholder. The death benefit is determined as the higher of a guaranteed amount and the account balance. [IFRS 17.B106]
B holds assets in Portfolio Z to cover both types of contracts and the expected annual return of the portfolio is 3.5%.
Although B expects both contracts to initially credit a 3% return on the policyholder’s account balance, only Contract Y creates a link between the policyholder’s return and a clearly identified pool of underlying items.
Although the obligation to the policyholder under Contract X reflects a crediting rate set by B that generally reflects B’s overall performance and expectations of the performance of the underlying assets that support the contract, it does not reflect clearly identified underlying items and therefore is not considered a direct participating contract.
Contract Y identifies a link to the assets in Portfolio Z and therefore could meet the definition of a direct participating contract.
Insurance contracts with direct participation features are insurance contracts that are substantially investment-related service contracts under which an entity promises an investment return based on underlying items. [IFRS 17 B101] Hence, they are defined as insurance contracts for which: Direct participating contracts
IFRS 17 B101 a) The contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items.
Includes any contract which creates a contractual obligation linked to underlying items. Direct participating contracts
- Explicit contractual terms Direct participating contracts Direct participating contracts
- Includes regulatory requirements Direct participating contracts Direct participating contracts
However, measurement based on expected cash flows (not contractually-specified cash flows). Not dependent on holding of underlying assets, e.g. could be related to an indexed fund. Obligations need not be to current generation of policyholders. Measurement of contracts using the variable fee approach. Direct participating contracts
Examples Direct participating contracts
Note Direct participating contracts
Unit-linked products Direct participating contracts
Choices of funds are transparent and clearly identified to policyholders
Universal Life Products Direct participating contracts
No clearly identified underlying items Direct participating contracts
What is the underlying? Direct participating contracts
IFRS 17 B106 The pool of underlying items referred to in paragraph B101 (a) (see a) above) can comprise any items, for example a reference portfolio of assets, the net assets of the entity, or a specified subset of the net assets of the entity, as long as they are clearly identified by the contract. An entity need not hold the identified pool of underlying items.
IFRS 17 BC245 ….The Board decided the underlying items do not need to be a portfolio of financial assets…. Direct participating contracts
…..seems to be quite an open definition!! Direct participating contracts
IFRS 17 B101 b) The entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items
- Unit Linked products: 100% of fund return Direct participating contracts
- Participating products: e.g. 90% policyholder fund’s surplus Direct participating contracts
Here are two schools of thought on how to calculate the return to the policy holder: Direct participating contracts
- Underlying items are simply the assets of the par fund – so that the fair value return on the underlying items is nothing but the investment return on those assets
- Underlying items are all forms of surplus – so that the fair value return on the underlying items includes investment returns, but also profits from mortality, expenses, lapsation etc
An example of the second assessment is as follows: Direct participating contracts
IFRS 17 B101 c) A substantial proportion of the cash flows the entity expects to pay to the policyholder should be expected to vary with the cash flows from the underlying items. Direct participating contracts
- Unit Linked products: Death benefit = Max(Fund Value, Sum Assured)
- Participating products: Reversionary Bonus, Terminal Bonus
Again two ways to approach this assessment:
- Under participating contracts, if the underlying fair value changes by an amount A, then the policyholder’s return increases by 90% x A. Therefore B101(c) may be satisfied (assuming guarantees have not bitten – see next below).
- A further condition may be tested – whether the amount of benefit that is variable is a substantial portion of the overall benefits given to the policyholder. If bonuses are a small component of overall benefits, then B101(c) is not satisfied.
Adjustments to the assessment:
There are some implicit assumptions used to establish: “Policyholders return = Return on assets less some deductions”
|Implicit assumption||Reference to IFRS 17 Insurance contracts|
|Guarantees have not bitten||IFRS 17 B107 – Need to assess on a probability weighted basis|
|Target is to deliver the asset share (or something similar) to a policyholder||IFRS 17 B103/IFRS 17 B68 –Need to reflect mutualisation (see further below) in the assessment|
… and now it even gets more technical, bare with me ……
IFRS 17 B107 …An entity shall…assess the variability in the amounts in paragraphs B101(b) and B101(c): … on a present value probability-weighted average basis, not a best or worst outcome basis…
Share of fair returns passed to policyholders
Probability of scenario
|Return on assets exceeds guaranteed benefits||
1 – p
|Return on assets is less than guaranteed benefits||
0% – benefits are fully guaranteed
Probability guarantee bites (p)
Share of fair returns passed to policyholders
IFRS 17 B101 (b) /(c) satisfied?
|5% – ‘low guarantee’||90% x (1-p) + 0% x p = 86%||
|50% – ‘high guarantee’||90% x (1-p) + 0% x p = 45%||
IFRS 17 B68 …. The fulfilment cash flows of each group reflect the extent to which the contracts in the group cause the entity to be affected by expected cash flows, whether to policyholders in that group or to policyholders in another group. Hence the fulfilment cash flows for a group:
- include payments arising from the terms of existing contracts to policyholders of contracts in other groups, regardless of whether those payments are expected to be made to current or future policyholders; and
- exclude payments to policyholders in the group that, applying (a), have been included in the fulfilment cash flows of another group.
Or in a picture:
Measurement of contracts with participation features
Entities that issue participating contracts (referred to in the standard as contracts with participation features) provide policyholders with a financial return on the premiums they pay by sharing the performance of underlying items with policyholders. Participating contracts can include cash flows with different characteristics, for example:
- Cash flows that do not vary with returns from underlying items, e.g., death benefits and financial guarantees
- Cash flows that vary with returns from underlying items — either via a contractual link to the returns on underlying items or through an entity’s right to exercise discretion in determining payments to policyholders
The cash flows of some contracts can affect the cash flows to other contracts via a process sometimes referred to as “mutualisation”.
IFRS 17 includes an adaptation to the general model to cater for some of these features. It distinguishes two types of contracts with participation features that are eligible for modifications to the general model: insurance contracts with direct participation features; and investment contracts with discretionary participation features. Direct participation features and discretionary participation features are explained below.
Insurance contracts with direct participation features apply a modified version of the general model called the variable fee approach. Insurance contracts without direct participation features must apply the general model without adaptation even though such contracts may have participation features. Participating contracts are not excluded from applying the premium allocation approach, but they may be unlikely to meet the eligibility criteria (as the coverage period may be significantly in excess of one year).
There is a wide variety of participating contracts in issue worldwide. For example, in Germany, insurance companies must return at least 90% of the investment profits on certain contracts to the policyholders, but may give more.
In other European countries, realised investment gains are distributed to the policyholder, but the insurance company has discretion over the timing of realising the gains. In the United Kingdom, bonuses are added to the policyholder account at the discretion of the insurer. Typically, these are based on the investment return generated by the underlying assets, but sometimes they include allowance for profits from other contracts.
Participation in underlying items can be discretionary (e.g., in the case of with-profit or universal life contracts); or they can be non-discretionary (e.g., In the case of unit linked contracts, where all returns on underlying items are paid to policyholders without the exercise of discretion).
For IFRS 17 measurement purposes the distinction between contracts with direct participation features, and those without direct participation features is important.
Determining how to faithfully represent the complex features of some participating contracts was one of the greatest challenges the IASB faced in finalising IFRS 17.
It is important to note that the differences between the variable fee approach for direct participation contracts and the general model applied to all other contracts exist for subsequent measurement only. As the requirements for initial measurement are the same for both models, any differences in measurement on initial recognition between contracts would be the result of differences in the terms and conditions of those contracts, but not the application of different measurement models.
Direct participating contracts
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