Estimates of future cash flows

Estimates of future cash flows – The first element of measuring fulfilment cash flows in the general model (see ‘General model of measurement of insurance contracts‘) is an estimate of future cash flows within the contract boundary period of each contract in a group.

Here is how the estimates of future cash flows fit into the general model of measurement of insurance contracts. The general model is based on the following estimation parameters:

Estimates of future cash flows should [IFRS 17 33]: Estimates of future cash flows

  • Include all cash flows that are within the contract boundary (see below) Estimates of future cash flows

  • Incorporate, in an unbiased way, all reasonable and supportable information available without undue cost or effort about the amount, timing and uncertainty of those future cash flows (see below) Estimates of future cash flows

  • Reflect the perspective of the entity, provided that estimates of any relevant market variables are consistent with observable market prices for those variables (see below) Estimates of future cash flows

  • Be current (based on actual data on the measurement date), and explicit (No historical model but based on current insights of the future)

Future cash flows characteristics

An entity may estimate the future cash flows at a higher level of aggregation than a group and then allocate the resulting fulfilment cash flows to individual groups of contracts.

Cash flows referred to in IFRS 17 are primarily payments of cash exchanged between the parties under an insurance contract in accordance with the terms and conditions of the contract. The term “cash flow” can also be used as shorthand for other transfers of economic resources (cash flow equivalents) that are not settled in cash between the parties to the insurance contract.

They may also include such items as administration costs, payments to third parties and non-cash transactions such as the provision of goods and services. Estimates of future cash flows


Insurance contract boundary

Identifying the contract boundary under IFRS 17 is fundamental to the measurement of the fulfillment cash flows of a group of contracts.

Cash flows are within the boundary (see below) of an insurance contract if they arise from substantive rights and obligations that exist during the reporting period in which the entity can compel the policyholder to pay the premiums or in which the entity has a substantive obligation to provide the policyholder with services. A substantive obligation to provide services ends when [IFRS 17 34]: Estimates of future cash flows

  • The entity has the practical ability to reassess the risks of the particular policyholder and, as a result, can set a price or level of benefits that fully reflects those risks; or
  • Both of the following criteria are satisfied: Estimates of future cash flows
    • The entity has the practical ability to reassess the risks of the portfolio of insurance contracts that contains the contract and, as a result, can set a price or level of benefits that fully reflects the risk of that portfolio. Estimates of future cash flows
    • The pricing of the premiums for coverage up to the date when the risks are reassessed does not take into account the risks that relate to periods after the reassessment date.

A liability or asset relating to expected premiums or claims outside the boundary of the insurance contract must not be recognized. Such amounts relate to future insurance contracts [IFRS 17 35].

IFRS 17 does not explicitly state whether the boundary condition relating to repricing for risk refers to insurance risk only or whether it also reflects other types of risk under the contract. At the February 2018 meeting of the Transition Resources Group, the IASB staff expressed the view that it was only the policyholder risk that would be relevant. This is risk that the policyholder transfers to the insurer under the contract. Lapse risk therefore would not be considered (except in the case of a reinsurance contract). Estimates of future cash flows

Essentials

  • Establishing the boundary of a contract is crucial as it determines the cash flows that will be included in its measurement. Drawing a contract boundary at the point where the entity has the practical ability to reprice (or amend the benefits under the contract) to fully reflect the risks of the policyholder may not reflect the entity’s expectations about future cash flows from renewals. This could result in contracts being reported as onerous even when an insurer expects to recover all costs from future renewals.
  • An entity’s ability to reprice an individual insurance contract (and a policyholder’s option not to renew the contract) creates a contract boundary. This means that, if premiums are received from the policyholder after the contract boundary date (i.e., the contract continues beyond the boundary period) this will treated as the recognition of a new contract — even if the rights and obligations of the entity and the policyholder are included within the single original policy document. The consequence would be that payments and related future cash flows will be recognized as new separate contracts. This is likely to result in a change from how entities deal with future premiums under current practices.
  • An entity might expect renewal of contracts subject to repricing and, consequently, would be willing to pay commissions and other acquisition expenses to acquire a contract that it may be unable to claw back if a contract does not renew. Accounting for the payment of insurance acquisition cash flows on insurance contracts which are expected to last for many years, but where the contract boundary is much shorter, may cause a profit or loss mismatch.For example, an insurer may pay significant up-front insurance acquisition cash flows in the first year of a contract on the basis of the expectation that the contract will renew for a number of years, but the contract boundary may be only one year. Absent claw-back provisions that would permit the insurer to recoup some of these cash flows in the event of non-renewal, the size of the acquisition cash flows may mean that the one-year contract is onerous.

Examples

Contract boundary of a stepped premium life insurance contract

An entity issues a group of insurance contracts that provide cover for death, and total and permanent disablement. The cover is guaranteed renewable (i.e., the entity must accept renewal) for 20 years regardless of changes in the insured’s health. However, the premiums increase annually with the age of the policyholder and the insurer may increase premium rates annually so long as the increase is applied to the entire portfolio of contracts (premium rates for an individual policyholder cannot be increased after the policy is underwritten).

Analysis Estimates of future cash flows

The contract boundary is one year. The guaranteed renewable basis means that the entity has a substantive obligation to provide the policyholder with services. However, the substantive obligation ends at the end of each year. This is because the entity has the practical ability to reassess the risks of the portfolio that contains the contract. Therefore, it can set a price that reflects the risk of that portfolio.

The pricing of the premiums for coverage up to the date when the risks are reassessed does not take into account the risks that relate to premiums after the reassessment date (as premiums are adjusted annually for age). Therefore, both criteria in paragraph 34(b) (ii) (see above) are satisfied. Estimates of future cash flows

Contract boundary of a level premium life insurance contract

An entity issues a group of insurance contracts that provide cover for death, and total and permanent disablement. The cover is guaranteed renewable (i.e., the entity must accept renewal) for 20 years regardless of changes in the insured’s health. The premium rates are level for the life of the policy irrespective of policyholder age. Therefore, the entity generally will “overcharge” in the early years of a contract and “undercharge” in the later years.

In addition, the insurer may increase the remaining year’s level premium annually so long as the increase is applied to the entire portfolio of contracts (premium rates for an individual policyholder cannot be increased after the policy is underwritten). Estimates of future cash flows

Analysis Estimates of future cash flows

The contract boundary is 20 years. The guaranteed renewable basis means that the entity has a substantive obligation to provide the policyholder with services. The substantive obligation does not end until the period of the guaranteed renewable basis expires. Although the entity has the practical ability to reassess the risks of the portfolio that contains the contract and, therefore, can set a price that reflects the risk of that portfolio, the pricing of the premiums does take into account the risks that relate to premiums after the reassessment date.

The entity charges premiums in the early years to recover the expected cost of death claims in later years. Therefore, the second criterion for drawing a shortened contract boundary when an entity can reassess the premiums or benefits for a portfolio of insurance contracts is not satisfied. Estimates of future cash flows


Cash flows within the contract boundary

Cash flows within the boundary of an insurance contract are those that relate directly to the fulfilment of the contract, including those for which the entity has discretion over the amount or timing. IFRS 17 provides the following examples of such cash flows [IFRS 17 B65]:

  • Premiums and related cash flows
  • Claims and benefits, including reported claims not yet paid, incurred claims not yet reported and expected future claims within the contract boundary
  • Payments to policyholders (or on behalf of policyholders) that vary depending on underlying items
  • Payments to policyholders resulting from embedded derivatives, for example, options and guarantees
  • An allocation of insurance acquisition cash flows attributable to the portfolio to which the contract belongs
  • Claims handling costs 
  • Contractual benefit costs paid in kind
  • Policy administration and maintenance costs, including recurring commissions that are expected to be paid to intermediaries
  • Transaction-based taxes and levies (such as premium taxes) Estimates of future cash flows
  • Payments by the insurer in a fiduciary capacity to meet tax obligations incurred by the policyholder, and related receipts
  • Claim recoveries, such as salvage and subrogation (to the extent they are not recognised as separate assets)
  • An allocation of fixed and variable overheads directly attributable to fulfilling insurance contracts. (Such overheads are allocated to groups of contracts using methods that are systematic and rational, and are consistently applied to all costs that have similar characteristics)
  • Any other costs that may be charged specifically to the policyholder under the terms of the contract Estimates of future cash flows
  • Insurance acquisition cash flows are those arising from the cost of selling, underwriting and starting a group of insurance contracts that are directly attributable to the portfolio of insurance contracts to which the group belongs. Such cash flows include cash flows that are not directly attributable to individual contracts or groups of insurance contracts within the portfolio.

There is no restriction of insurance acquisition cash flows to only those resulting from successful efforts. Therefore, the directly attributable costs of an underwriter of a portfolio of motor insurance contracts, for example, need not be apportioned between costs for contracts issued and the cost of efforts that did not result in the issuance of a contract.

IFRS 17 provides a list of cash flows that should not be included in cash flows that arise as an entity fulfils an existing insurance contract, these include, for example [IFRS 17 B66]:

  • Investment returns (accounted for separately under applicable IFRSs)
  • Cash flows (payments or receipts) that arise under reinsurance contracts held (accounted for separately)
  • Cash flows that may arise from future insurance contracts, i.e., cash flows outside the boundary of existing contracts
  • Cash flows relating to costs that cannot be directly attributed to the portfolio of insurance contracts that contain the contract, such as some product development and training costs; these are recognised in profit or loss when incurred
  • Cash flows that arise from abnormal amounts of wasted labour or other resources that are used to fulfil the contract; such costs are recognised in profit or loss when incurred
  • Income tax payments and receipts the insurer does not pay or receive in a fiduciary capacity
  • Cash flows between different components of the reporting entity, such as policyholder and shareholder funds, if these cash flows do not change the amounts paid to policyholders
  • Cash flows arising from components separated from the insurance contract and accounted for using other applicable IFRSs

Considerations

  • As a change to many existing accounting practices under IFRS 4, no explicit deferred acquisition cost assets exist. Instead, the insurance acquisition cash flows are included as a “negative liability” within the measurement of the CSM on initial recognition. Because the CSM can never be negative, there is no longer a need to perform any recoverability assessments for acquisition costs deferred.
  • Investment returns are not part of the fulfilment cash flows of a contract because measurement of the contract should not depend on the assets that the entity holds. However, where a contract includes participation features, the measurement of the fulfilment cash flows should include the effect of returns from underlying items in those cash flows.The “Illustrative Examples” that accompany IFRS 17 explain that asset management is part of the activities the entity must undertake to fulfil the contract when there is an account balance calculated using returns from specified assets and fees charged by the entity (see illustration 5 in section 3.3).In general, an entity should incorporate asset management expenses in a way that is consistent with how it considers the returns from the assets it is holding in the estimates of fulfilment cash flows, based on the product features. So if investment returns from underlying items are included in fulfilment cash flows then the asset management expenses that relate to those returns should also be included.
Something else -   Transition to IFRS 17 Insurance contracts

Incorporate all reasonable and supportable information available without undue cost or effort

The objective of estimating future cash flows is to determine the expected value, or the probability-weighted mean, of the full range of possible outcomes, considering all reasonable and supportable information available at the reporting date without undue cost or effort [IFRS 17 B37].

An entity need not identify every possible scenario. The complexity of techniques an entity uses to estimate the full range of outcomes will depend on the complexity of the cash flows of a group of insurance contracts and the underlying factors that drive cash flows. In some cases, relatively simple modelling may give an answer within an acceptable range of precision, without the need for many detailed simulations.

However, in some cases, the cash flows may be driven by complex underlying factors and may respond in a non-linear fashion to changes in economic conditions. This may occur if, for example, the cash flows reflect a series of interrelated options that are implicit or explicit. In such cases, it is likely that more sophisticated stochastic modelling will be necessary to satisfy the measurement objective.

The future cash flow estimates must be on an expected value basis and be unbiased. This means that they should exclude any additional estimates above the probability-weighted mean for “uncertainty”, “prudence” or what is sometimes described as “management loading”. The risk adjustment for non-financial risk is intended to reflect the compensation for bearing the non-financial risk resulting from the uncertain amount and the timing of cash flows.

Reasonable and supportable information available at the reporting date without undue cost or effort includes information available from an entity’s own information systems about past events and current conditions, and forecasts of future conditions. An entity should estimate the probabilities and amounts of future payments under existing contracts based on information obtained, including [IFRS 17 B41]:

  • Information about claims already reported by policyholders
  • Other information about the known or estimated characteristics of the insurance contracts
  • Historical data about the entity’s own experience, supplemented when necessary with data from other sources. Historical data is adjusted to reflect current conditions, for example, if:
    • Characteristics of the insured population differ (or will differ, for example, because of adverse selection) from those of the population that has been used as a basis for the historical data.
    • There are indications that historical trends will not continue, that new trends will emerge or that economic, demographic and other changes may affect the cash flows that arise from the existing insurance contracts.
    • There have been changes in items such as underwriting and claims management procedures that may affect the relevance of historical data to the insurance contracts. Information collection insurance contracts
  • Current price information, if available. The standard refers to reinsurance contracts and other financial instruments (if any) covering similar risks, such as catastrophe bonds and weather derivatives, and recent market prices for transfers of insurance contracts.

The measurement of a group of insurance contracts should reflect, on an expected value basis, the entity’s current estimates of how the policyholders in the group will exercise the options available, e.g., renewal, surrender and conversion options, and options to stop paying premiums while still receiving benefits under the contracts.

Considerations

  • Techniques such as stochastic modelling may be more robust or easier to implement if there are significant interdependencies between cash flows that vary based on returns on assets and other cash flows. Judgement is required to determine the technique that best meets the objective of consistency with observable market variables in specific circumstances.

  • Some insurers currently include management loadings or other forms of prudence within insurance liabilities. Implicit prudence in reserving tends to reduce volatility in profits. IFRS 17 requires calculation and disclosure of a point estimate of the mean of the expected future cash flows discounted to the reporting date with an explicit risk margin for non-financial risk. Insurers will need to educate investors about the potential effect of IFRS 17 on reported profits if they expect that the volatility of their results is likely to increase when they apply IFRS 17.


Market variables and non-market variablesIFRS 17 Insurance contracts Contents

IFRS 17 identifies two types of variable that can affect cash flow estimates [IFRS 17 B42]:

  • Market variables (i.e., those that can be observed in, or derived directly from, markets (for example, prices of publicly-traded securities and interest rates))
  • Non-market variables (i.e., all other variables, such as the frequency and severity of insurance claims and mortality)

Market variables

Market variables affect estimates of cash flows in participating contracts (contracts with participation features), and non-participating contracts, e.g., if cash flows vary with changes in an index for price inflation.

Estimated cash flows reflect the perspective of the entity, provided that estimates of any relevant market variables are consistent with observable market prices for those variables. IFRS 17 has similar requirements to IFRS 13 Fair Value Measurement for maximising the use of observable inputs when estimating market variables [IFRS 13 3]. Consistent with IFRS 13, if variables need to be derived (for example, because no observable market variables exist) they need to be as consistent as possible with observable market variables [IFRS 17 B44].

The standard refers to the notion of a replicating asset or replicating portfolio of assets as a means of measuring the liability based on market information. A replicating asset is one whose cash flows exactly match, in all scenarios, the contractual cash flows of a group of insurance contracts in amount, timing and uncertainty. In some cases, a replicating asset may exist for some of the cash flows that arise from a group of insurance contracts.

The fair value of that asset reflects both the expected present value of the cash flows from the asset and the risk associated with those cash flows. If a replicating portfolio of assets exists for some of the cash flows that arise from a group of insurance contracts, the entity can use the fair value of those assets to measure the relevant fulfilment cash flows instead of explicitly estimating the cash flows and discount rate [IFRS 17 B46].

IFRS 17 does not require an entity to use a replicating portfolio technique. Judgement is required to determine the technique that best meets the objective of consistency with observable market variables in specific circumstances. In particular, the technique used must result in the measurement of any options and guarantees included in the insurance contracts being consistent with observable market prices (if any) for such options and guarantees [IFRS 17 B48].

The application guidance is clear that although market variables will generally provide a measurement basis for financial risks (e.g., observable interest rates) this will not always be the case. The same is true for non-financial risks and non-market variables. For example, some non-financial risks could be observable in markets, whereas not all financial risks will be observable.

In practice, we believe that the use of a replicating portfolio is likely to be rare as IFRS 17 refers to an asset whose cash flows exactly match those of the liability.

Non-market variables

Estimates of non-market variables should reflect all reasonable and supportable evidence available without undue internal or external cost or effort [IFRS 17 B49]. Entities need to assess the persuasiveness of information from different sources, as shown below:

Persuasiveness of internal and national mortality statistics [IFRS 17 B50]

An entity that issues life insurance contracts should not rely solely on national mortality statistics. It should consider all other reasonable and supportable internal and external information available without undue cost or effort when developing unbiased estimates of probabilities for mortality scenarios for its insurance contracts. For example:

  • Internal mortality statistics may be more persuasive than national mortality data if national data is derived from a large population that is not representative of the insured population.
  • Conversely, if the internal statistics are derived from a small population with characteristics that are believed to be close to those of the national population, and the national statistics are current, an entity should place more weight on the national statistics.

Estimated probabilities for non-market variables should not contradict observable market variables. For example, estimated probabilities for future inflation rate scenarios should be as consistent as possible with probabilities implied by market interest rates [IFRS 17 B51].

In some cases, market variables and non-market variables may be correlated. For example, there may be evidence that lapse rates (a non-market variable) are correlated with interest rates (a market variable) [IFRS 17 B52].

Similarly, there may be evidence that claim levels for house or car insurance are correlated with economic cycles and therefore with interest rate inflation. The entity should ensure that the probabilities for scenarios and risk adjustments for non-financial risk that relate to market variables are consistent with the observed market prices that depend on those variables [IFRS 17 B53].


Using current estimates

Estimated cash flows should be current, i.e., reflect conditions existing at the measurement date, including assumptions about the future. An entity should review and update its estimates from the close of the previous reporting period. In doing so, an entity should consider whether updated estimates faithfully represent the conditions at the end of the reporting period and changes during the period [IFRS 17 B54].

Faithful representation of conditions at the reporting date and changes in the period

If conditions have not changed in a period, shifting a point estimate from one end of a reasonable range at the beginning of the period to the other end of the range at the end of the period would not faithfully represent what has happened during the period.

If the most recent estimates are different from previous estimates, but conditions have not changed, an entity should assess whether the new probabilities assigned to each scenario are justified. In updating its estimates of those probabilities, the entity should consider both the evidence that supported its previous estimates and all newly available evidence, giving more weight to the more persuasive evidence.

An entity should not update probabilities for claim events to reflect actual claims that took place after the reporting date but before the financial statements are finalised. For example, there may be a 20% probability at the end of the reporting period that a major storm will strike during the remaining six months of an insurance contract. After the end of the reporting period, but before the financial statements are authorised for issue, a major storm strikes.

The fulfilment cash flows under that contract should not reflect hindsight (i.e., the storm that occurred in the next period). Instead, the cash flows included in the measurement should include the 20% probability apparent at the end of the reporting period (with disclosure applying IAS 10 Events After the Reporting Date that a non-adjusting event occurred after the end of the reporting period) [IFRS 17 B55 and IAS 10 10-11].

Explicit cash flows

An entity estimates future cash flows separately from other estimates, e.g., the risk adjustment for non-financial risk or the adjustment to reflect the time value of money and financial risks. There is an exception if the entity uses the fair value of a replicating portfolio of assets to measure some of the cash flows that arise from insurance contracts.

This will combine the cash flows and the adjustment to reflect the time value of money and financial risks. The fair value of a replicating portfolio of assets reflects both the expected present value of cash flows from the portfolio of assets and the associated risk (see Market variables above).

Some existing accounting practices incorporate implicit margins for risk in a best estimate liability. For example, determining the liability for incurred claims based on an undiscounted management best estimate, which often incorporates conservatism or implicit prudence.

IFRS 17 appears to require a change to this practice such that incurred claims liabilities must be measured at the discounted probability-weighted expected present value of the cash flows, plus an explicit risk adjustment. Entities will need to be more transparent in providing information about how liabilities related to insurance contracts are made up.

Estimates of future cash flows

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Something else -   Measurement under IFRS

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