[IFRS 17 Insurance Contracts] The Variable Fee Approach (‘VFA’) is a modification of the General Model. The General Model is applied to insurance contracts without participation features or to insurance contracts with participation features that fail the Variable fee scope test.
Variable fee scope test
Thus, the VFA is applied to insurance contracts with direct participation features that contain the following conditions (‘eligibility criteria’) at initial recognition:
- the contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items;
- the entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and
- a substantial proportion of the cash flows the entity expects to pay to the policyholder should be expected to vary with cash flows from the underlying items.
In order to be in scope of the VFA, an insurance contract would need to meet all the three eligibility criteria stated above, and this eligibility test is only performed at inception. In addition, it is noted that the definition refers only to the terms of the insurance contract, and therefore it is not necessary that the entity holds the identified pool of underlying items.
In contracts that qualify for the VFA, the entity has an obligation to pay to the policyholder an amount equal to the share of the return on the fair value of the underlying items less an insurer’s fee in exchange for the future services provided by the insurance contract.
Any changes to the insurer’s fee (as a result of changes arising from financial risk and non-financial risk that affect the underlying items) are taken to the contractual service margin (‘CSM’) and recognised in profit or loss via the release/allocation of the CSM to profit or loss.
Differences between the Variable Fee Approach and the General Model
|General model||Variable fee approach|
|Accretion of interest on CSM||Locked-in rate||Current rate|
|Changes in market variables including options and guarantees||Recognised in either (a) profit or loss or (b) profit or loss and OCI||Changes in shareholders’ share of underlying items including options and guarantees are recognised in CSM (unless CSM reaches zero)|
|Changes in market variables – Application of risk mitigation||IFRS 9 hedge accounting techniques are applicable, subject to fulfilment of conditions1.||Subject to specific criteria, an entity can elect not to recognise in CSM changes in shareholders’ share or the effect of financial guarantees|
Accretion of interest on CSM
In the General Model [IFRS 17 Insurance Contracts], the Contractual Service Margin (CSM) is accreted in each reporting period using the discount rate at inception of the insurance contract (i.e. a locked-in rate).
However, there is no explicit accretion of the CSM under the VFA. Under the VFA, the total liability is adjusted, through the Statement of Comprehensive Income, to reflect the change in the value of all the underlying items, including those underlying items ascribed to the shareholder (shareholders share). The portion of this change attributable to the shareholders’ share captures both the effect of the passage of time, and the change in the value of the underlying assets. Therefore, the CSM for the VFA is considered to be based on current discount rates.
Changes in market variables including options and guarantees
Under both the General Model and the VFA, entities can make an accounting policy choice between:
- Inclusion of insurance finance income or expenses in profit or loss; or
- Disaggregation of insurance finance income or expenses.
Determining how to disaggregate insurance finance income or expenses differs between a defined subset of contracts accounted for under the VFA and all other contracts. Under both approaches, the disaggregation is between profit or loss and other comprehensive income. Under both approaches, the disaggregation has the purpose to include in profit or loss an amount that partly or wholly eliminates accounting mismatches with the finance income or expenses on assets held. In general, the entity is required to predetermine which portfolios of liabilities will be disaggregated, and which will not. However, for contracts under the Variable Fee Approach, if the entity elects or is required to hold the underlying assets on its balance sheet, then in that specific circumstance, the entity will determine the disaggregation for the liability based on the disaggregation outcome for those underlying assets. In those circumstances, this results in amounts recognised in other comprehensive income equalling to zero.
Under the Variable Fee Approach, where the entity holds the underlying items and chooses to disaggregate insurance finance income or expenses between P&L and OCI, the finance income or expenses included in P&L will exactly match that on the underlying items resulting in nil investment margin in P&L. In practice, it is common for there to be a non-zero OCI balance, e.g. where there are assets valued at amortised cost or where there are duration mismatches between assets and liabilities.
As an illustration, consider the treatment of changes in the financial risk relating to options and guarantees embedded in an insurance contract. For example, a change in the discount rate may change the value of the options and guarantees.
- In the General Model, an entity may choose to either account for this in (a) profit or loss or in (b) profit or loss and other comprehensive income.
- In the VFA, the effect of changes in financial risk on options and guarantees is regarded as part of the variability of the insurer’s fee for future service, and hence recognised in CSM, unless CSM becomes zero. At that moment, the effect of the financial guarantee is recognised in the statement of comprehensive income under both the General Model and the VFA.
In addition, under the VFA, the CSM is unlocked for the effect of all changes in the fulfilment cash flows, other than changes that arise from changes in the underlying items. Consequently, changes in, for example, the value of options and guarantees are treated as a change to the balance of CSM, and are not recorded in comprehensive income. Under the general model, these changes would flow through the Statement of Comprehensive Income.
Changes in market variables – Application of risk mitigation
Hedging adjustment for the Variable Fee Approach
As stated in ‘Accretion of interest on CSM’ above, in the VFA, the CSM is adjusted for the effect of changes in financial risk, for example interest rates, on the entity’s share of the underlying items or on the fulfilment cash flows.
However, if, as part of its risk management activities, an entity hedges itself against financial market risks using a derivative, the entity may choose to adjust profit or loss for the effect of those changes in financial risk. This will address the accounting mismatch that would have been created because the effects of the changes in value of the derivative are recognised in profit or loss, while changes in the value of a guarantee embedded in the insurance contract would adjust the CSM under the VFA. This option has the purpose to bring the VFA closer to the General Model.
In the General Model, there is an accounting policy choice for the effect of changes in financial risk. That is, an entity may choose to either account for this in (a) profit or loss or in (b) both profit or loss and other comprehensive income. Hedge accounting under IFRS 9 Financial Instruments can be used to resolve the accounting mismatches resulting from the effects of changes in financial risk.« Go to IFRS Jargon