Significant insurance risk – How 2 best account it under IFRS 17

Significant insurance risk – An insurance contract is only in the scope of IFRS 17 if it transfers a significant amount of insurance risk to the entity (or reinsurer).

Insurance risk is only significant if there is at least one scenario with commercial substance where the compensation paid by the insurer is significant, disregarding the likelihood of that scenario. If commercial substance exists only in very unlikely scenarios, but the contract covers all these scenarios, then this qualifies as being significant (see IFRS 17 B18).

Insurance risk can already be significant even if the policyholder still has to opt for insurance cover in the future, but with insurance rates already specified. Also, an insurance contract remains an insurance contract even if the original insurance risk has expired (unless a specified contract modification has occurred.

IFRS 17 requires that the compensation and its commercial substance be considered on a present value basis, unlike IFRS 4, which did not require the use of present values in making this assessment.

Separation of Insurance Contracts

Before the entity accounts for an insurance contract based on the guidance in IFRS 17, it should analyse whether the contract contains components that should be separated. IFRS 17 distinguishes between three different kinds of component that have to be accounted for separately if certain criteria are met: Significant insurance risk

  • embedded derivatives; Significant insurance risk
  • investment components; and Significant insurance risk
  • promises to transfer distinct goods (thus non-insurance) or distinct non-insurance services. Significant insurance risk

The sections below explain each of these items in more detail. Significant insurance risk

Significant insurance risk

Discretionary participation features = the part of an insurance contract where an insurer shares the performance of underlying items with policyholders/insured (i.e. additional payment). The amount or timing of this additional payment is contractually at the discretion of the issuer/insurance company. Significant insurance risk

Separating components to financial instrument components (embedded derivative or investment component IFRS 9) or product or servicing components (IFRS 15) (IFRS 17 10 – 13, IFRS 17 B31 – B35) Significant insurance risk

Investment contract (IAS 39 Term) = Investment component accounting for separately from the insurance component under  IFRS 9 (IFRS 17 11(b))

Investment contract with discretionary participation features

In summary: Significant insurance risk

IFRS 17 requires all rights and obligations from a group of insurance contracts to be presented net in one line in the statement of financial position, unless the components of the insurance contract are separated (that is, embedded derivatives and distinct investment and service components (IFRS 17 11)).

An entity applies IFRS 17 to all remaining components of the contract. Separation of other non-insurance components is prohibited.

Prohibition on voluntarily separating components of an insurance contract

Under IFRS 17 separation of any components is prohibited unless it is explicitly required under the standard. This might have a significant effect on some entities. For example, a bank might issue loans that are waived if the borrower dies. Significant insurance risk

Under IFRS 4, the bank could have voluntarily separated the contract into a loan accounted for at amortised cost, similar to other loans, and the insurance component accounted for under IFRS 4. Under the new standard, the loan element is unlikely to qualify as a distinct investment component (see below), and so the entire contract will be required to be accounted for as an insurance contract. Significant insurance risk

Contracts with riders

Insurers often issue contracts with riders. A rider is an add-on provision to a basic insurance policy that provides additional benefits to the policyholder at an additional cost. Riders can be either part of a contract at inception or added subsequently. Irrespective of when the riders are issued they can be priced at inception or subsequently in line with the prices at the date when the rider is issued. The accounting for riders depends on the terms of the contracts.

Riders that are separate policies or insurance contractsSignificant insurance risk

If riders are issued and priced separately from the base insurance contracts, they should be viewed as separate insurance contracts for IFRS 17, unless required to be bundled together under the combination guidance.

Riders that are issued together with the main insurance contract and form part of a single insurance contract

If there is only one insurance contract with multiple provisions, and all of the riders are within the boundary of that contract, the contract will be viewed as one contract for IFRS 17.

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Embedded derivatives

An entity applies the guidance in IFRS 9, ‘Financial Instruments’, to determine whether an embedded derivative should be separated. Under IFRS 9, an embedded derivative is separated if all of the following criteria are met: Significant insurance risk

  • The economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host.
  • A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative. Significant insurance risk
  • The hybrid contract is not measured at fair value with changes in fair value recognised in profit or loss. Significant insurance risk

The guidance in IFRS 9 makes clear that the linkage of contractually required payments to an equity index or a debt index that reflects the credit risk of the underlying debt instruments issued by a third party is, in general, not closely related. For insurance contracts, IFRS 9 and IFRS 17 include two important exemptions. Significant insurance risk

  • First, IFRS 9 explains that derivatives embedded in an insurance contract are closely related to the insurance contract and are not separated if the embedded derivative and the host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately without considering the host contract.
  • Second, IFRS 17 notes that the payment of an amount linked to a price index does not give rise to a non-closely related embedded derivative if the payment itself is triggered by an insured event and the transfer of insurance risk is significant. Significant insurance risk

Investment components

In a second step, an entity separates any investment component that is distinct. An investment component is the amount that the insurer has to repay to the policyholder, even if the insured event does not occur.  Significant insurance risk

The component is distinct if both of the following criteria are met: Significant insurance risk

  • The investment component and the insurance component are not highly interrelated. The two components are highly interrelated if the value of one component varies with the value of the other component and hence the entity is unable to measure each component without considering the other. The components are also highly interrelated if the policyholder is unable to benefit from one component unless the other is also present. This is, for example, the case if the maturity or lapse of one component causes the maturity or lapse of the other component.
  • A contract with terms equivalent to the investment component is sold, or could be sold, separately in the same market or same jurisdiction. An entity takes into account all reasonably available information when it makes this assessment, but it does not have to undertake an exhaustive search. Significant insurance risk

An investment component that is separated from the insurance contract is accounted for as a financial instrument within the scope of IFRS 9. An investment component that is non-distinct and is not separated from an insurance contract for the purpose of measurement should nevertheless be excluded from both insurance revenue and insurance service expenses.

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Promises to transfer distinct goods or non-insurance services

In a final step, after separating non-closely related embedded derivatives and distinct investment components, an entity should separate from the host insurance contract any promise to transfer distinct goods or non-insurance services to a policyholder. Significant insurance risk

A good or non-insurance service is distinct if the transferee can benefit from the good or service either on its own or together with other resources that are readily available. A resource is readily available if it is either sold separately or the transferee already owns it. Significant insurance risk

A good or non-insurance service is not distinct if the cash flows and risks associated with that good or service are highly interrelated with those of the insurance component and the entity provides a significant service in integrating the good or service with the insurance component. Significant insurance risk

Activities that an insurer has to perform to fulfil the insurance contract, such as administrative tasks to set up the contract, are not separated. In general, processing the claims received is part of the activities that the insurer must undertake to fulfil the contract and is not a distinct service that should be separated. There are, however, exceptions, in particular if the insurance company provides the service to an entity that self-insures a part of its risks.

Illustrative Example 5 to IFRS 17 demonstrates a contract with a distinct service component that should be separated.

Once the entity has concluded that a promise to transfer goods or non-insurance services is accounted for separately, it should allocate the cash flows to the insurance component and any promises to provide goods or non-insurance services accounted for separately.

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A comprehensive example of how components are separated from an insurance contract is included in Illustrative Example 4 to IFRS 17.

Insurance risks – Other risks

Distinction between insurance risk and other risks

  • Financial risk: Change in interest rate, security price, commodity price, etc.: NOT insurance risk
  • Lapse, persistency or expense risk: NOT insurance risk in direct contract
  • Contracts including both financial risk and significant insurance risk have insurance risk
  • Must relate to uncertain future event that adversely affects the policyholder
  • Must be a pre-existing risk vs. risk created by the contract

Significance test: – Compare:
(1) Cash flows that would be paid if the insured event occurredSignificant insurance risk
Versus
(2) Cash flows that would be paid if no insured event occurred

• Are cash flows under (1) > (2)?
• Are additional benefits significant?
• Does the scenario have commercial substance?
• Evaluated on a contract-by-contract basis

Determining Insurance Risk

Simplified Example of 7 year endowment product. Death benefit equals the endowment benefit.

Scenario 1

Policyholder dies in first policy month and received 134k

Scenario 2

Policyholder survives to endowment and receives 134k, PV = 90k

Both are insurance risks.

Other illustration: Credit cards that provide insurance coverage

Some credit card contracts may provide insurance coverage and transfer significant insurance risk from the cardholder.

Fact pattern

Credit Card Issuer C provides insurance coverage for purchases that the cardholder makes using the credit card. C would pay the cardholder for claims resulting from a supplier’s misrepresentation or breach of contract. Under this arrangement, C either:

  • charges no fee to the cardholder for this service; or
  • charges an annual fee that does not reflect an assessment of the insurance risk associated with that individual cardholder.

Analysis

The credit card contract contains both insurance and non-insurance components. This could pose a challenge for C because:

  • the requirements in IFRS 17 for separating non-insurance components differ from those in IFRS 4, as explained in the table below; and
  • IFRS 4 is less prescriptive about how any insurance component is measured.

Separating non-insurance parts

IFRS Requirements for separating non-insurance components (excluding embedded derivatives)
IFRS 4 10-12 Permits an insurer to separate a loan component from an insurance contract and apply IFRS 9 (or IAS 39) to the loan component.
IFRS 17 10 – 13 Generally requires IFRS 17 to be applied to the whole contract that transfers significant insurance risk.

Separation is permitted only in narrower circumstances than under IFRS 4. Specifically, an insurer separates investment components and goods or non-insurance services components if they are distinct.

Stakeholders are concerned that credit card issuers that currently account for a loan or a loan commitment in a credit card contract under IFRS 9 (or IAS 39) would need to change the accounting for those contracts that transfer significant insurance risk when IFRS 17 becomes effective – only a short time after having incurred costs to develop a new credit impairment model to comply with IFRS 9.

Significant insurance risk

Significant insurance risk

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