Variable fee approach

[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 approach

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Variable fee scope test

Thus, the Variable Fee Approach is applied to insurance contracts with direct participation features that contain the following conditions (‘eligibility criteria’) at initial recognition:

  1. the contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items; Variable fee approach
  2. the entity expects to pay to the policyholder an amount equal to a substantial share of the returns from the underlying items; and Variable fee approach
  3. 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 Variable Fee Approach, 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 Variable Fee Approach, 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. Variable fee approach

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. Variable fee approach

Overview Variable Fee Approach

Variable fee approach
* Except to the extent that risk mitigation does not apply (see below)

Differences between the Variable Fee Approach and the General Model

Variable fee approach General model Variable fee approach
Accretion of interest on the contractual service margin 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

Variable fee approach

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 the contractual service margin

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 Variable Fee Approach. Under the Variable Fee Approach, 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 Variable Fee Approach is considered to be based on current discount rates.

Changes in market variables including options and guarantees

Under both the General Model and the Variable Fee Approach, entities can make an accounting policy choice between:

  1. Inclusion of insurance finance income or expenses in profit or loss; or Variable fee approach
  2. Disaggregation of insurance finance income or expenses. Variable fee approach

Determining how to disaggregate insurance finance income or expenses differs between a defined subset of contracts accounted for under the Variable Fee Approach 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. Variable fee approach

  1. 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.
  2. In the Variable Fee Approach, 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 Variable Fee Approach.

In addition, under the Variable Fee Approach, 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. Variable fee approachVariable fee approach

Changes in market variables – Application of risk mitigation

Hedging adjustment for the Variable Fee Approach Variable fee approach

As stated in ‘Accretion of interest on the contractual service margin‘ above, in the Variable Fee Approach, 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 Variable Fee Approach. This option has the purpose to bring the Variable Fee Approach 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. Variable fee approach

Example

This example has been developed based on a single economic scenario for reasons of simplification. In practice, insurers would consider a weighted average outcome of many different economic scenarios producing different outcomes. This may influence the example in some areas.

The insurance case

– Assumptions

Company A (the “Company”) signs 6-year life insurance contracts with an Insurer for its 100 employees (the “policyholders”). At inception, the Company pays the Insurer a single premium of CU 1.000.000 (CU 10.000 per employee). During the life of the contract:

  1. The policyholders will receive the higher of: Variable fee approach
    1. a minimum guaranteed amount of 3,00% over the premium, paid every year; and
    2. 85% of the returns of the underlying assets. The remaining 15% of the asset returns is considered as the fee for the Insurer. For a description of how the Insurer’s fee is determined, refer to Insurer’s fee below. Variable fee approach
  2. The Insurer promises that it will pay back 120% of the nominal amount (CU 12.000) per policyholder in case of death, even if adverse economic scenarios have affected the initial nominal investment. The Insurer estimates that 1,00% of the policyholders present at inception will die annually. The policyholder also receives the minimum guarantee during the year of his/her death; Variable fee approach
  3. In case of a policyholder leaving the company (i.e. the policy lapsing), the Insurer promises that the policyholder receives the premium paid (CU 10.000), even if adverse economic scenarios have affected the initial nominal investment. The Insurer estimates that 1,00% of the policyholders present at inception will leave the Company annually.Any policyholder whose contract lapses is not entitled to the minimum guarantee during the year of his/her lapse, and instead that amount is paid in the year of the lapse occurring to the remaining policyholders in the portfolio2; and Variable fee approach
  4. The portfolio benefits from cash flows coming from another portfolio when the asset returns are insufficient to pay for the minimum guaranteed amount, i.e. this mutualisation only covers the minimum guarantee, not the principal amount of the premium paid. No mutualisation payments to the other portfolio need to be made.

At the end of year 6, the Insurer will make a terminal pay-out to each remaining policyholder based on the premium outstanding, if any, i.e. the Insurer pays out CU 10.000 in case the asset returns over the life of the contract allow to do so. It is noted that any positive return is paid out separately as part of the top-up return (see the contract policies a) – d) above).

All events and changes in discount rates occur at the end of each reporting period except for:

  1. the payment of the premiums by the Company, which happens at inception of the contract; Variable fee approach
  2. the investment in financial assets made by the Insurer, which happens immediately after receiving the premiums at the start of the contracts; Variable fee approach
  3. the determination of the expected credit loss allowance for the bonds accounted for by the Insurer at fair value through other comprehensive income (‘FVOCI’), which happens at initial recognition of the financial assets; and Variable fee approach
  4. The change from equity pool A to equity pool B which takes place at the beginning of year 20X5. Variable fee approach

The contracts in the example are contracts with discretionary participation features. Variable fee approach

The Insurer considers that the 100 insurance contracts form a group of contracts for the purpose of measurement.

– Underlying assets

Immediately after receiving the premiums from the Company, the Insurer invests 65% of the premiums in a pool of equities3 of country A, measured at fair value through profit or loss (FVPL) under IFRS 9. The remaining 35% of the premiums is invested in a pool of fixed-rate bonds with an annual interest rate of 3.50%, measured at fair value through other comprehensive income (FVOCI) under IFRS 9. These assets collectively form the underlying items promised to the policyholders, and are held on the balance sheet.

At inception, the Insurer expects that the returns of both the equities and bonds will be sufficient to pay at least the minimum guarantee promised to the policyholders. Each year, in case of a death or a lapse occurring and if the cash inflows from asset returns and mutualisation are not sufficient to pay the promised amounts to the policyholders, the Insurer sells part of the equities in order to pay these claims. Variable fee approach

Every year, the Insurer estimates the weighted average rate of the asset returns of the underlying assets based on the fixed rate of the bonds and an estimated change in fair value of the equities.

In case of death, the Insurer will pay the mortality component of the payment to the policyholder (CU 2.000) from the cash account comprising the accumulated fees.

At the end of year 20X3, the Insurer notes that the equity investments of country A are insufficient for the Insurer to pay out a minimum guarantee of 3.00% to the policyholders. As a result, the mutualisation clause is triggered and the deficit in pay-out is covered by the mutualised cash flows coming from another portfolio. Variable fee approach

At the end of year 20X4, the Insurer estimates that the equity investments of country A are now expected to continue to fail to cover the minimum guarantee to the policyholders. Consequently, the Insurer transfers the pool of equities – at the beginning of year 20X5 – to its general fund at fair value, and replaces those equities with a pool from country B with better prospects, also at fair value. The actual asset returns for each year are as follows:

Actual asset returns3

20X1

20X2

20X3

20X4

20X5

20X6

Equities from country A

4.50%

4.00%

2.55%

3.55%

N/A

N/A

Equities from country B

N/A

N/A

N/A

N/A

3.75%

3.80%

Bonds

3.50%

3.50%

3.50%

3.50%

3.50%

3.50%

The roll-forward of the assets is split into investment in equities, investment in bonds and the Insurer’s bank account as follows4:

– Investment in bonds

Actual Variable fee approach

Inception

20X1

20X2

20X3

20X4

20X5

20X6

Opening balance Variable fee approach

350,000

350,000

349,000

354,537

355,313

351,555

349,290

Fair value change5

5,537

776

-3,758

-2,265

-290

Interest return6

12,250

12,250

12,250

12,250

12,250

12,250

Payments to policyholders

-12,250

-12,250

-12,250

-12,250

-12,250

-12,250

Derecognition of the Bonds

-350,000

Expected Credit Losses

-1,000

1,000

Closing balance

350,000

349,000

354,537

355,313

351,555

349,290

– Investment in equities

Actual Variable fee approach

Inception

20X1

20X2

20X3

20X4

20X5

20X6

Opening balance

650,000

650,000

630,000

600,000

580,000

550,000

530,000

Fair value change

29,250

25,200

15,300

20,590

20,625

20,140

Sales Variable fee approach

-49,250°

-55,200

-35,300

-50,590

-40,625

-40,140

Derecognition of equities

-510,000

Closing balance

650,000

630,000

600,000

580,000

550,000

530,000

° During 20X1 the Insurer is paying CU 63.500 to the policyholder of which CU 2.000 (mortality component) will be paid with the Insurer’s own money. To face these, payments the Insurer is receiving CU 12.250 from the bonds so it needs to sell equities for an amount of CU 49.250 to cover the difference. Note the fair value change of the bonds is ignored following the decision not to sell any of the bonds.

– Insurer’s Bank account summary

Actual

Inception

20X1

20X2

20X3

20X4

20X5

20X6

Initial Cash

1,000,000

4,225

7,843

5,843

6,769

9,700

Investments purchased

-1,000,000

860,000

Cash in from investments

– Bonds Variable fee approach

12,250

12,250

12,250

12,250

12,250

12,250

– Equities Variable fee approach

49,250

55,200

35,300

50,590

40,625

40,140

Cash out to policyholders

-61,500

-67,450

-47,550

-62,840

-52,875

-912,390

Cash in from other portfolio7

650

Cash out to policyholders

-650

Net Insurer’s fee

6,225

5,618

4,926

4,931

4,859

Mortality component of the payments in case of death

-2,000

-2,000

-2,000

-4,000

-2,000

-2,000

Closing balance

4,225

7,843

5,843

6,769

9,700

12,559

Insurance contract liability

– Discounting

The expected future cash flows are initially discounted at 3,77% at inception. That discount rate reflects the returns of the underlying assets and is calculated as a weighted average effective interest rate (‘EIR’). This is done as follows8: (link note)

  1. First, the future equity return rates for the entire duration of the contract are estimated. In the example, the arithmetic average of this future estimated return rates equals 3,92% at inception. The future interest return rate of the bonds are as the coupon is fixed and equals 3,50%, and this rate is also the average.Even when the bonds are held in a business model for both collecting cash flows and selling the assets, it is assumed that the bonds will be held till maturity and will not be sold to take advantage of any fair value change.
  2. Second, estimated return rates of both the equities and the bonds are weighted (65% equities, 35% bonds in year 1) in order to define the overall discount rate for the total asset portfolio.

As a result, the actual discount rate in each year for the liability is adapted as follows. It is noted that the actual asset mix is not updated for determining the annual weighted average EIR.

20X1

20X2

20X3

20X4

20X5

20X6

Weighted average EIR

3.77%

3.31%

3.09%

3.36%

3.68%

3.68%

Theoretically the cash flows that vary directly based on the underlying items separately from the ones that do not vary directly based on the underlying items (in this example, the mortality risk of CU 2.000 per policyholder, the cash flows expected to be paid under the guarantee and the expected cash flows as a consequence of mutualisation) should have been discounted. These cash flows would be discounted at a rate that reflects the variability arising from the underlying assets, while the other cash flows would be discounted at a rate that reflects the characteristics of those cash flows.

The future IFRS 17 will not require the entity to split the estimated cash flows for discounting. Instead, the standard requires that the discount rate reflect the characteristics of all the cash flows, and leaves it to the entity to determine what method best achieves this. For purposes of determining an average EIR over time, an entity should weigh the rate for the expected occurrence of cash flows over that time period.

In this example, the guarantee and mutualisation cash flows (the uncertainty of whether these will be activated being reflected in the time value of options and guarantees (TVOG)). This is commonly understood to be consistent with what the Standard requires. However, for reasons of simplicity and materiality, the example uses a weighted average EIR derived from the expected asset returns as a discount rate for all cash flows (i.e., a discount rate that completely reflects the underlying items).

Because the Insurer holds the assets, it is allowed to make an accounting policy choice to account for the effect of the change in discount rates eliminating accounting mismatches arising with the underlying assets held.

– Death benefits and lapses

At inception, the Insurer expects 1,00% of the initial group to die each year (i.e. one death pa). The Insurer also expects 1,00% of the initial group to lapse each year (i.e. one lapse pa). In the case of a lapse, the policyholder is not entitled to the minimum guarantee during the year of his/her lapse.

– Mutualisation

The portfolio benefits from cash flows coming from another portfolio. When the asset returns are insufficient to pay for the minimum guaranteed amount, the policyholders from the other portfolio cover the difference by providing additional cash flows up to the amount of the minimum guarantee. The mutualisation clause is part of the contract from inception.

How does mutualisation work

Mutualisation may interact with the level of aggregation for the determination of a group of onerous contracts and for the allocation of the CSM. The term mutualisation is when the returns from the underlying items is reduced for policyholders in order to pay other policyholders who share the returns from the same identified pool of underlying items.

– Insurer’s fee

The Insurer’s fee is 15% of the asset returns. However, this fee is constrained by the effect of the minimum guarantee. If the asset returns are not sufficient to cover both the guarantee and the Insurer’s fee, the Insurer’s fee is limited to the amount available after paying the guarantee. If the asset returns are less than or equal to the minimum guarantee, the Insurer receives no fee.

At inception, the contractual service margin (CSM) is lower than the net present value of the expected Insurer’s fee. This is because the contractual service margin represents the unearned profit after considering the insurers’ fee, the insurance cash outflows, insurance risk and the value of financial guarantees and options in the contract. For an analysis of the ratio contractual service margin compared to Insurer’s fee see below.

– Risk adjustment

The risk adjustment is estimated at CU 4,000 at inception of the contract and remeasured, on a yearly basis. As a simplification, the risk adjustment is allocated, based on the number of policyholders remaining in the Company in each reporting period, to the Statement of Profit or Loss – Underwriting, as follows:

20X1

CU

Opening balance

4,000

Unwinding the discount rate for Risk

151

Calculation using 3.77% over the opening balance

Allocation of Risk in P&L

-728

Calculation made based on the number of contracts in force, at the start of 20X1 (100 policyholders)

Closing balance

3,423

Note that the accounting treatment for the risk adjustment is done the same way as in an application of the General Model.

– Time value of options and guarantees

Since the Insurer promises a minimum guaranteed amount of 3,00% of the premium to be paid every year to the policyholders, there is uncertainty of the amount of loss the Insurer may incur due to market performance. This is sometimes referred to as a measure of the time value of options and guarantees (‘TVOG’).

As a result, at inception, the Insurer assigns an amount CU 1009 as the TVOG. This is not part of the risk adjustment.

Note that, for simplicity reasons, the accounting treatment of the time value of options and guarantees is the same as for the risk adjustment and is illustrated as follows.

20X1

CU

Opening balance

100

Unwinding the discount rate for Risk

4

Calculation using 3.77% over the opening balance

Allocation of Risk in P&L

-18

Calculation made based on the number of contracts in force, at the start of 20X1 (100 policyholders)

Closing balance

86

– Fulfilment cash flows

The above assumptions are reflected in the following fulfilment cash flows at inception, which are discounted at 3,77% (see assumptions a) – d) above). These are estimations at inception.

Estimated Fulfilment Cash Flows at Inception

Inception

20X1

20X2

20X3

20X4

20X5

20X6

Cash inflows

+++++ Premiums

-1,000,000

Cash outflows

+++++ Terminal pay-out

880,000

+++++ Top up return

11,800

8,350

6,930

6,770

4,900

7,000

3.00%+ Min. Guarantee

29,700

29,100

28,500

27,900

27,300

26,700

+++++ Expect. of death

1.00%   (capital amount)

10,000

10,000

10,000

10,000

10,000

10,000

+++++ (mortality)

2,000

2,000

2,000

2,000

2,000

2,000

1.00% Expect. of lapse

10,000

10,000

10,000

10,000

10,000

10,000

+++++ Insurer’s fee

-6,225

-5,618

-5,315

-5,201

-4,830

-5,055

Risk

4,000

TVOG

100

++++++++ TOTAL

-995,900

57,275

53,833

52,116

51,470

49,370

930,645

The net present value (NPV) of these estimated cash outflows at inception amounts to CU 982.540. Cash outflows are discounted at 3,77%.

The asset returns are taken into account in the projection of cash outflows in the determination of policyholder’s benefit and the Insurer’s fee. This is because the obligation to the policyholder is related to the asset returns – in contrast to the General Model – and the determination of the discount rate that is being used.

– Contractual service margin (CSM)

Based on the previous estimated fulfilment cash flows, the contractual service margin (‘CSM’), at inception, is determined as follows:

Calculation of CSM at inception

CU

Variable fee approach

Present value of cash inflows

-1,000,000

Present value of cash outflows

982,540

Risk adjustment

4,000

Time value of options and guarantees

100

Fulfilment cash flows

-13,360

Contractual service margin

13,360

The CSM is allocated to the Statement of Profit or Loss – Underwriting result based on the number of policyholders remaining in the Company in each reporting period, as follows.

20X1

CU

Opening balance

13,360

Change in value of underlying assets

41,500

Change in value of fulfilment cash flows

-37,206

Unlocking for effect of changes relating to underlying items – note no experience adjustment in Y20X1

4,583

Allocation of CSM in P&L

-3,901

Calculation made based on the number of contracts in force, at the start of 20X1 (100 policyholders)

CSM Closing balance

18,336

In summary, the actual changes over the years are as follows:

Year 20X1

Everything happens as expected.

Year 20X2

Change in actual asset return rate of the underlying assets of equities from 4,50% to 4,00%, change in discount rate for the future cash flows liability from 3,77% to 3,31%, unexpected additional lapse, increase in risk adjustment of CU 400 and increase in TVOG of CU 15.

Year 20X3

Change in actual asset return rate of the underlying assets of equities from 4,00% to 2,55% and for the future cash flows liability from 3,31% to 3,09%. Asset return is insufficient to cover minimum guarantee, therefore, deficit is covered by mutualised cash flows. There is an increase in TVOG of CU 30. In addition, the entity recognises a loss and creates a loss component tracked separately (The loss component in year 20X3 of CU 1,663). Insurer receives no fee.

Year 20X4

Change in actual asset return rate of the underlying assets of equities from 2,55% to 3,55%, change in discount rate for the future cash flows liability from 3,09% to 3,36%, unexpected additional death and increase in risk adjustment of CU 440. Asset return is sufficient to cover minimum guarantee and CSM recovers. Loss component is reversed.

Year 20X5

As asset returns insufficient to cover minimum guarantee, equity portfolio A is prospectively replaced with equity portfolio B which has an asset return rate of 3,75%. Change in liability discount rate from 3,36% to 3,68%. There is a decrease in TVOG of CU 45.

Year 20X6

Change in equity portfolio B return from 3,75% to 3,80%.

VFA – Statement of Comprehensive Income, Balance Sheet and Cash Flow Statement

Variable fee approach

Variable fee approach

Accounting entries VFA Example

The accounting entries relating to the above example for the years 20X3 and 20X5 are provided here: Variable fee approach

Reporting period 20X3

In the reporting period 20X3, no unexpected events occur from an insurance risk perspective (i.e. deaths or lapses). Instead, the unexpected events explained below relate to the assets supporting the insurance liability. Variable fee approach

At the end of reporting period 20X3, the equity returns are insufficient to cover the minimum guaranteed amount. This triggers the mutualisation clause incorporated in the insurance contract from inception. Policyholders from another portfolio will pay the difference between the asset return earned and the minimum guarantee to be paid out.

The Insurer re-estimates the expected future cash flows of the contracts, as follows: Variable fee approach

Table Estimated cash flows at 31 December 20X3 Variable fee approach

Variable fee approach

The NPV of estimated cash outflows at the end of year 3 amounts to CU 932.904 using 3.09%. Variable fee approach

– Assets

The Insurer estimates the asset returns and compares it to the estimated minimum guarantee to determine whether cash flows as a result of mutualisation is needed:

Variable fee approach

Note: Asset returns consists of the interest return of the bonds and the fair value change of the equities. Note that the fair value change of the bond is not considered an available cash flow as a result of the decision not to sell any of the bonds. Variable fee approach

The Insurer obtains the following return on investment assets. The fair value of equities increases by CU 15.300 (Accounting entry Y3.1). The interest return from the fixed-rate bonds amounts to CU 12.250 (Accounting entry Y3.2). The fair value of the bonds increases by CU 776 (Accounting entry Y3.3).

Therefore, total asset return is CU 28.326. However, in order to consider the obligation towards the policyholders, the asset returns of 27.550 are taken into account (excluding the fair value change of the bonds).

Variable fee approach

In Year 20X3, the asset return of CU 27.550 is not sufficient to pay the minimum guarantee of CU 28.200. Ignoring the fair value of the bonds as discussed above, a difference of CU 650 comes from mutualised cash flows from another portfolio (Accounting entry Y3.4).

Considering the asset returns, an amount of CU 650 is necessary to be able to pay the minimum guaranteed amount. The mutualised cash inflows, in this example, are treated as cash amounts which go to the Insurer’s bank account. But there may be alternative ways to do the accounting for the mutualised cash flows. Variable fee approach

Variable fee approach

In doing the estimations for future periods, the Insurer also tests whether the shareholders will be able to receive the Variable fee entirely. That is, the Insurer tests whether the amounts to be paid as minimum guarantee are lower than or at least equal to 85% of the asset returns in all periods. The Insurer’s estimates reveal that for Years 20X5 and 20X6, the asset returns will be insufficient to pay out the minimum guarantee with 85% of the asset returns. Variable fee approach

Therefore, in this example, the Insurer chooses to reduce its fee with the amounts of the shortfall in both periods. In the table above, the Insurer’s fee for Years 20X5 and 20X6 is therefore reduced to CU 2.050 and CU 3.670 respectively. Variable fee approach

The Insurer has to pay the policyholders a total amount of CU 50.200 (Payments of minimum guarantee of CU 28.200, lapse of CU 10.000 and death of CU 12.000) (See below Minimum guarantee of 3.00%, death benefit and lapse Accounting entry 3.9). In order to pay this amount, the Insurer does the following:

  1. In order to pay the remaining minimum guarantee of CU 27.55010, the Insurer receives interest from the bonds of CU 12.250 (see above Assets Accounting entry Y3.2) and the remaining part is funded via a sale of equities.
  2. The Insurer needs to also fund the claims relating to the lapse and death. Therefore, it sells additional equities amounting to CU 20.000 (this amount represents the lapse payment of CU 10.000 and death payment – capital amount of CU 10.000). Variable fee approach
  3. Note that the asset returns are only sufficient to cover the minimum guarantee and as a result, the policyholders do not receive a top-up over the minimum guarantee nor does the Insurer receive its fee in year 20X3. Variable fee approach
  4. Part of the payment amounting to CU 650 comes from mutualisation to cover the minimum guarantee (refer to Assets above).

The total equities sold are CU 35.30011 (Accounting entry Y3.5). Note that the Insurer has to pay CU 12.000 and not CU 10.000 to the policyholder that died, the extra CU 2.000 is paid from the Insurer’s bank account.

This amount comes from the Insurer’s ‘own pocket’ as this represents an adverse outcome of the insurance risk the insurer has agree to take and this is reflected in Accounting entry Y3.9 (see below Minimum guarantee of 3.00%, death benefit and lapse). Variable fee approach

Variable fee approach

In summary:

To be paid to policyholders Variable fee approach Variable fee approach

50,200

Cash available from mutualisation Variable fee approach Variable fee approach

-650

Cash available from interest on bonds Variable fee approach Variable fee approach

-12,250

Amount Insurer pays from its ‘own pocket’ Variable fee approach Variable fee approach

-2,000

Equities to be sold

35,300

– Insurance contract liability – Future Cash Flows

The table below is a reconciliation of the future cash flows for year 20X3:

20X3

CU

Carrying amount of the future cash flows at end of 20X2 Variable fee approach Variable fee approach

944,808

Effect of the passage of time Variable fee approach Variable fee approach

31,288

Effect of actual payments of claims Variable fee approach Variable fee approach

-50,200

Effect of mutualisation Variable fee approach Variable fee approach

650

Effect of change in discount rate Variable fee approach Variable fee approach

5,794

Changes in estimates relating to the future Variable fee approach Variable fee approach

564

Carrying amount of future cash flows at end of 20X3

932,904

– Discounting

The discount rate changes at the end of the reporting period, i.e. at the end of year 3, the discount rate used by the Insurer to determine the present value of the re-estimated future cash flows changes from 3,31% to 3,09%. Variable fee approach

The Insurer qualifies to use the current period book yield approach since it holds the assets and has chosen to do so, hence the Insurer disaggregates insurance finance income or expenses for the period to include in the statement of profit or loss an amount that eliminates accounting mismatches with the finance income or expenses arising on the underlying items held. It is recalled that part of the underlying assets is invested in equities held at FVPL, another part is invested in bonds held at FVOCI.

The discount rate for the insurance liability future cash flows is unwound for an amount of CU 31.288 using the current rate for the year of 3,31% (Accounting entry Y3.6). This amount goes to the Statement of Profit or Loss – Investment results. Variable fee approach

Variable fee approach

In order to determine the change in estimates related to the future for the year-end 20X3 of CU 564 (Accounting entry Y3.7), one estimates the future cash flows using the rate of the year 3,31% and compares that to the cash flows that were estimated at the end of year 20X2 using the same rate of 3,31%, as follows: Variable fee approach

Variable fee approach

The resulting journal entry Y3.7 is as follows: Variable fee approach

Variable fee approach

– Minimum guarantee of 3.00%, death benefit and lapse

Referring to Assets above – (and scroll to -) the Insurer has to pay the policyholders CU 50.200 needs to be paid to the policyholders.

Therefore, the liability for remaining coverage related to provision for the lapse, minimum guarantee of 3,00% and death benefit is released for an amount of CU 50.200. That amount represents investment component for an amount of CU 48.200 and insurance component for CU 2.000 (Accounting entry Y3.8). Variable fee approach

Variable fee approachThe same amount CU 50.200 is paid to the policyholders (Accounting entry Y3.9). This amount represents investment component for an amount of CU 48.200 and insurance component for CU 2.000. Variable fee approachVariable fee approach

– Changes in discount rates

In order to determine the effect of the change of discount rate from 3,31% to 3,09% for the future cash flows, one calculates the NPV of re-estimated future cash flows at the end of year 20X3 using 3,31% and compares the same future cash flows using 3,09%, as follows:

Variable fee approach(*) Calculation using 3,09% (rate end of year) for the above cash flows
(**) Calculation using 3,31% (rate for the year) for the above cash flows

The difference arising from the change in discount rate of CU 5.794 represents the effect of the change in discount rates from 3,31% to 3,09% of future cash flows (Accounting entry Y3.10).

Variable fee approach

– Insurance contract liability – Risk Adjustment

The risk adjustment is unwound using current rates (3,31%) for an amount of CU 103 (Accounting entry Y3.11). Variable fee approach

Variable fee approach

The risk adjustment is allocated to profit or loss for an amount of CU 832 based on the number of contracts in force at the start of the year (Accounting entry Y3.12).

Variable fee approach

– Insurance contract liability – TVOG

As mentioned in the assumptions, as a simplification, the TVOG is accounted for in the same way as the risk adjustment. The TVOG is unwound using current rates (3,31%) for an amount of CU 3 (Accounting entry Y3.13). Variable fee approach

Variable fee approach

In year 20X3, as the asset returns are not enough to cover the minimum guarantee, the Insurer considers that there is an uncertainty of the amount of loss it may incur in the future due to market performance. Therefore, the Insurer decides to increase the TVOG by CU 30 (Accounting entry Y3.14) and as this relates to the future, it is debited to CSM.

Variable fee approach

The TVOG is allocated to profit or loss for an amount of CU 30 based on the number of contracts in force at the start of the year (Accounting entry Y3.15). Please note that this CU 30 is not the same as CU 30 explained in Accounting entry Y3.14. It is, by coincidence, the same amount. Variable fee approach

Variable fee approach

– CSM

The change in the value of the Insurer’s share of underlying items is accounted for in CSM for a net amount of negative CU 8.862 (Accounting entry Y3.16). That amount is composed of the following gross amounts: Variable fee approach

  1. the change in value of the underlying assets is accounted for in CSM for an amount of CU 28.326 (refer to Assets – above); and
  2. the unwind of the discount rates for the future cash flows liability CU 31.288, risk adjustment CU 103 and TVOG CU 3 and the effect of changes in liability discount rates CU 5.794 are accounted in CSM for a total amount of negative CU 37.188. Variable fee approach

The CSM is adjusted for a change in future estimates amounting to negative CU 564 (refer to Changes in estimates related to the future first section).

CSM is debited for an amount of CU 30 due to an increase in the TVOG (refer Changes in estimates related to the future first section).

As a result of the above, there is a loss of CU 1.663 and this loss goes to the Statement of Comprehensive Income – Underwriting result but it does not form part of revenue (Accounting entry Y3.17).

Variable fee approach

By definition CSM cannot be negative and as a result in such situations, the standard requires an entity to create a separate loss component of the liability and allocate on a systematic basis the subsequent changes in fulfilment cash flows between the liability for remaining coverage and the liability for the loss component.

In this example, the loss for an amount of CU 1.663 compared to the total liability for fulfilment cash flows at the end of year 3 for an amount of CU 935,381 is considered to be immaterial. Hence, in this example no allocation is made of subsequent changes in fulfilment cash flows recognised in statement of comprehensive income for simplicity reasons. Variable fee approach

Instead, the loss component has reversed in the next period in profit or loss because in the following year, the CSM is naturally re-built.

Statement of comprehensive income

– Determination of the underwriting result in profit or loss

There is no allocation of CSM to profit or loss because there is no positive CSM. The loss is accounted directly to the Statement of Comprehensive Income – Underwriting result (Accounting entry Y3.17 (in CSM)). This loss is not part of revenue but is part of the underwriting result. Variable fee approach

The annual allocation of the risk adjustment CU 832 and TVOG CU 30 to profit or loss is accounted for as part of the underwriting result (Accounting entries Y3.12 (in Insurance contract liability – Risk Adjustment) and Y3.15 (in Insurance contract liability – TVOG)). Variable fee approach

Part of the release of the provision of the future cash flows liability that is related to the insurance component is accounted for as revenue (Accounting entry Y3.8 (in Minimum guarantee of 3.00%, death benefit and lapse )). That is, an amount if CU 2.000 is the insurance component. The same amount is presented as claims paid. (refer to Minimum guarantee of 3.00%, death benefit and lapse – accounting entry Y3.9). Variable fee approach

The total revenue for the year 20X3 is CU 2.862, the incurred claims are negative CU 2.000 and the impact of the loss component is negative CU 1.663 resulting in an underwriting loss of CU 801.

– Determination of the investment result in profit or loss

The assets generate a return of CU 27.550 which is accounted for as part of the investment result (Accounting entries Y3.1 and Y3.2 (in Assets)). This comprises the fair value change of the equities and the interest income from the bonds. Variable fee approach

The unwinding of the discount rate for the insurance liability future cash flows of CU 31.288 (Accounting entry Y3.6 (in Discounting)), the risk adjustment of CU 103 (Accounting entry Y3.11 (in Insurance contract liability – Risk Adjustment)) and the TVOG for an amount of CU 3 (Accounting entry Y3.13 (in Insurance contract liability – TVOG)) are accounted for as part of the investment result.

The VFA the entity’s share of the fair value of the underlying assets is part of the consideration and, as such, any change is recognised in CSM. Thus, the change in value of the Insurer’s share of underlying items of CU 8.862 is also accounted for as part of the investment result (refer CSM first section) against CSM.

Furthermore, as the Insurer holds the underlying assets it shall include in profit or loss and/or OCI, expenses or incomes that exactly match the income or expenses included in profit or loss and/or OCI for the underlying items, resulting in the net of the two separate items being nil in profit or loss and/or OCI.

Thus, the investment result is adjusted for the change in discount rates relating to the liability future cash flows for a net amount of negative CU 5.018 (Accounting entry Y3.10 (in Changes in discount rates)). That net amount is composed of the change in discount rates for an amount of negative CU 5.794 and an adjustment to OCI for an amount of CU 776 in order to resolve the accounting mismatch with the fair value change of the bonds.

The adjustment to OCI of CU 776 is computed as follows: Variable fee approach

Changes in the fulfilment cash flows liability for 20X3 Variable fee approach

CU

Unwinding of discount rate for future cash flows liability (see CSM first section) Variable fee approach

31,288

Unwinding of discount rate for risk adjustment (see Insurance contract liability – Risk Adjustment) Variable fee approach

103

Unwinding of discount rate for TVOG (see Insurance contract liability – TVOG accounting entry Y3.13) Variable fee approach

3

Changes in discount rates (see Changes in discount rates accounting entry Y3.10) Variable fee approach

5,794

A – Total

37,188

Asset returns in P&L (see Assets – after the table) Variable fee approach

27,550

plus Insurer’s share of the value of the underlying items (see CSM first section) Variable fee approach

8,862

B – Asset returns less Insurers’ share

36,412

Difference recorded in OCI (A – B)

776

As part of the investment result, there is a release of the future cash flows provision of CU 48.200 (refer to Minimum guarantee of 3.00%, death benefit and lapse accounting entry Y3.8 (in Minimum guarantee of 3.00%, death benefit and lapse)) and payment of claims of the same amount (refer to Minimum guarantee of 3.00%, death benefit and lapse accounting entry Y3.9 (in Minimum guarantee of 3.00%, death benefit and lapse)).

Overall, this results in an investment result of CU 0 for the year 20X3 due to the elimination of accounting mismatches.

Therefore, overall the loss is CU 801 (i.e. CU 801 underwriting loss and CU 0 investment result). Variable fee approach

– Determination of other comprehensive income

The fair value of the bonds is adjusted for an amount of CU 776. As the financial assets are held at FVOCI, the amount is credited to OCI (Accounting entry Y3.3 (in Assets above)).

Also, changes in discount rates for the liability future cash flows of negative CU 776 goes to OCI resolving the accounting mismatch (Accounting entry Y3.10 )in Changes in discount rates).

Overall, this results in a total OCI-amount of CU 0 for the year 20X3. Variable fee approach

The total comprehensive result for the year 20X3 is therefore a loss of CU 801 (i.e. CU 801 overall loss and OCI CU 0).


Determination of the asset returns (Explanation of discounting above)

In the VFA, the asset returns play an important role as they are projected into the cash outflows of the liability. In this chapter, additional background is provided on the asset returns and how these are calculated.

As mentioned in Underlying assets (first caption), 65% of the premiums received are invested in a pool of equity instruments of country A, measured at fair value through profit or loss, 35% is invested in a pool of fixed-rate bonds with an annual interest rate of 3.50%, measured at fair value through other comprehensive income (‘OCI’) under IFRS 9.

The minimum guarantee offered in the contract is 3,00%, which implies that the asset returns, on average, should be higher to ensure profitability.

The estimation of the interest returns of the bond are straightforward as these are fixed interest rate payments for a rate of 3,50%.

Equity returns are by definition variable. In this case, for discounting purposes, the asset return for every period is to be estimated, or an average effective interest rate can be used. In this example n average effective interest rate is being used. Variable fee approach

At inception, the estimated asset returns of the equity portfolio are: Variable fee approach

Variable fee approach

20X1

20X2

20X3

20X4

20X5

20X6

Variable fee approach
Variable fee approach

4.50%

4.00%

3.80%

3.80%

3.50%

3.90%

Variable fee approach

This results in average effective interest rate for the equity portfolio A of 3,92% at inception. For simplification purposes, an arithmetic average has been used.

The weighted average EIR for the complete portfolio, at inception, is 3.77%12.

This exercise is done every year again, based on new estimations from the asset and liability management from the Insurer. During the life of the contract, equities are being sold to cover the cash shortfalls in paying out the policyholders.

Thus, the weighted average will shift as the weights of the underlying asset classes will differ over time. For reasons of simplification this has not been incorporated in the example. The following returns are being used.

Variable fee approach Variable fee approach

20X1

20X2

20X3

20X4

20X5

EIR equities (65%)

3.92%

3.21%

2.86%

3.28%

3.78%

Return bonds (35%)

3.50%

3.50%

3.50%

3.50%

3.50%

Weighted average return used to discount the liability

3.77%

3.31%

3.09%

3.36%

3.68%

The table below presents the estimated asset returns for every year which have been used in this example.

Variable fee approach

Insurer’s fee discussion (Explanation for insurer’s fee above)

The contractual service margin (‘CSM’) represents, together with the risk adjustment (‘RA’) and the TVOG, if any, the unearned profit that the Insurer expects to realise as it provides services under the insurance contract.

Consistent with the General Model, the CSM together with the release of the provision for non-investment component future cash flows comprise the Insurance Revenue which is recognised as the services are provided. The insurer’s fee is the amount that the Insurer retains and is usually funded from the returns on the underlying items for the services provided.

At inception the NPV of net13 expected insurer’s fees (EIF) is captured in the following calculation relationship with the contractual service margin (CSM), the risk adjustment (RA) and the time value of options and guarantees (TVOG):

Variable fee approach

Additionally, at maturity where there are experience adjustments (i.e., the impact of variances between actual amounts and expectations):

Variable fee approach

Adjustments may need to be made to both the numerator and denominator depending if there are costs which are to be paid out of the Insurer’s fee.

The above considerations useful in enhancing understanding and analysis of the VFA but these are not IFRS 17 requirements. The above considerations may be used as a management tool.

Additionally, at maturity, the real insurer’s fee retained over the life of the contracts equals CU 26.558 (excluding the death benefits of CU 2.000 per policyholder). This amount matches the insurance revenue over the life of the contracts when being corrected for the experienced adjustments (unexpected events happening, lapse and death), so the second ratio above, at maturity, equals to 1. Variable fee approach

Consequently, both terms CSM and insurer’s fee are inter-related and represent the same expected profit. The adjective ‘expected’ is important as it clarifies the corrections for risk adjustment, TVOG and the unexpected events happening during the life of the contracts. Variable fee approach

Variable fee approach

Variable fee approach

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