The contractual service margin is calculated at the start of the contract as the difference between the present value of the expected cash flows (plus a risk adjustment) and the present value of expected premiums. In its simplest form, the contractual service margin represents the overall profit expected on the insurance contract.
The fulfillment cash flows represent the estimate of the present value of the future cash outflows less the present value of the future cash inflows that will arise as the entity fulfills the contract.
A key principle of IFRS 17 is that no gains are recognized when the contract starts because the entity has not yet satisfied any of its performance obligations. Instead, the contractual service margin is recognized as the entity satisfies the performance obligation.
Worked example: The timing of gains recognition
Imagine an entity receives $900 in premiums at the start of an insurance contract spanning 3 years. It calculates the expected cash outflows to have a present value of $600 ($200 each year), giving a contractual service margin (expected profit) of $300.
In year 1, the entity would record $300 in insurance revenue and $200 for incurred claims. As the entity has received $900 but recorded only $300 in revenue, the remaining $600 will be held as a liability.
This represents and must be disclosed as the fulfillment cash flows of $400 (to be incurred at $200 a year) and the remaining contractual service margin of $200 (the remaining unearned profit).
The liability will decrease to $300 at the end of year 2 as $200 fulfillment costs are incurred and a further $100 contractual service margin is earned, and it will be repeated in year 3.