Lifetime expected credit losses

Lifetime expected credit losses are the expected shortfalls in contractual cash flows, taking into account the potential for default at any point during the life of the financial instrument.

IFRS 9 draws a distinction between financial instruments that have not deteriorated significantly in credit quality since initial recognition and those that have. ‘12-month expected credit losses’ are recognized for the first of these two categories. ‘Lifetime expected credit losses’ are recognized for the second category.

Measurement of the expected credit losses is determined by a probability-weighted estimate of credit losses over the expected life of the financial instrument. An asset moves from 12-month expected credit losses to lifetime expected credit losses when there has been a significant deterioration in credit quality since initial recognition. Hence the ‘boundary’ between 12-month and lifetime losses is based on the change in credit risk not the absolute level of risk at the reporting date.

Finally, it is possible for an instrument for which lifetime expected credit losses have been recognized to revert to 12-month expected credit losses should the credit risk of the instrument subsequently improve so that the requirement for recognizing lifetime expected credit losses is no longer met.

The Expected Credit Losses (ECL) requirement in IFRS 9 makes the initial selection of bonds for fixed income investments by financial institutions much more important, as selecting bonds with good long-term credit health is key to reducing the risk of future P&L fluctuations caused by changes in ECL. This is especially important for insurers that would like to adopt a buy-and maintain bond investment strategy.

Under the “expected credit loss” model, an entity calculates the allowance for credit losses by considering on a discounted basis the cash shortfalls it would incur in various default scenarios for prescribed future periods and multiplying the shortfalls by the probability of each scenario occurring. The allowance is the sum of these probability weighted outcomes. Because every loan and receivable carries with it some risk of default, every such asset has an expected loss attached to it—from the moment of its origination or acquisition.

Lifetime expected credit losses

 

Something else -   The IFRS 9 Framework for financial assets

Lifetime expected credit losses (Stage 2 + 3 of the Three stages Expected Credit Losses) are the present value of expected credit losses that arise if a borrower defaults on its obligation at any point throughout the term of a lender’s financial asset (that is, all possible default events during the term of the financial asset are included in the analysis).

The requirements in IFRS 9 result in lifetime expected credit losses being recognised only when the credit risk of a financial instrument is worse than that anticipated when the financial instrument was first originated or purchased. If, at the reporting date, the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses [IFRS 9 5.5]. 12-month expected credit losses are defined as the expected credit losses that result from those default events on the financial instrument that are possible within the 12 months after the reporting date.

For a financial guarantee contract (see section 9 below), the guarantor is required to make payments only in the event of a default by the debtor in accordance with the terms of the instrument that is guaranteed. Accordingly, the estimate of lifetime ECLs would be based on the present value of the expected payments to reimburse the holder for a credit loss that it incurs less any amounts that the guarantor expects to receive from the holder, the debtor or any other party. If the asset is fully guaranteed, the ECL estimate for the financial guarantee contract would be the same as the estimated cash shortfall estimate for the asset subject to the guarantee.

12 month versus lifetime expected credit losses

Entity B has a reporting date of 31 December. On 1 July 20X1 Entity B advanced a 3-year interest-bearing loan of CU2,000,000 to Entity A. Management estimates the following risks of defaults and losses that would result from default at 1 July 20X1 and at 31 December 20X1 and 20X2:

Something else -   Expected credit losses on financial assets

Note that the probability that there will be no default is implicit in the percentages above. Note also that the loss that will transpire should a loss occur in the event of default in the next 12 months does not correspond to the expected cash shortfalls in the next 12 months.

What credit loss provision should Entity B book at:

  1. 1 July 20X1
  2. 31 December 20X1
  3. 31 December 20X2

Solution

At 1 July 20X1:

On initial recognition Entity B should recognise a credit loss provision equivalent to 12-month expected losses.

12-month expected loss = (2.5% * CU800,000] = CU20,000

At 31 December 20X1:
Entity B first evaluates whether credit risk has increased significantly since the loan was initially recognised (on 1 July 20X1). If Entity B has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low. The evaluations are as follows:

  • credit risk relative to initial recognition? The total risk of default has increased from 7.5% to 13.0% which is clearly significant
  • is absolute level of credit risk ‘low’? Although ‘low’ is not quantified, a 13.0% risk of default certainly appears to not be low. IFRS 9 B.5.5.23 refers to an example of low credit risk being an external rating of ‘investment grade’. The lowest rating generally considered investment grade is ‘BBB’ meaning adequate capacity to meet financial commitments. The credit loss provision should therefore be based on lifetime expected losses.
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Lifetime expected loss = (3.0%+10%) * CU700,000 = CU91,000

At 31 December 20X2:
Entity B again evaluates whether credit risk has increased significantly since 1 July 20X1. If Entity A has chosen to use the practical expedient for low credit risk, it also evaluates whether the absolute level of credit risk is low. The evaluations are as follows:

  • credit risk relative to initial recognition? The total risk of default has now decreased to 3.0% and is therefore lower than the risk at initial recognition of 7.5%
  • is absolute level of credit risk ‘low’? This evaluation is not relevant given there has not been a significant increase in the instrument’s credit risk compared to the level at initial recognition.

The credit loss provision should therefore return to being based on 12-month expected losses.

12-month expected loss = (1.0% * CU500,000) = CU5,000

General model of measurement of insurance contracts

Lifetime expected credit losses

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