2023 is a very important year for the insurance industry: The complex IFRS 17 framework was set in force on 1st January 2023 and replaces the interim standard IFRS 4 Phase I, which has been in force since 2005. The new standard regulates the principles for identification, recognition, measurement, presentation and disclosures for insurance contracts.
Alma is going to accompany the implementation of IFRS 17 by the insurance industry. Therefore, Alma will publish from time to time brief and well understandable articles on IFRS 17.
Part 3: Some technical aspects
In this part of the IFRS series, Alma would like to address some technical aspects that should facilitate the understanding and future handling of IFRS. Further descriptions and examples of technical aspects will follow in the future.
IFRS 17 addresses the treatment of insurance liabilities. It describes how they are to be calculated and how they are to be reported in the balance sheet as well as in the income statement (P&L).
Here, it helps to make a certain change in the way IFRS 17 is considered in order to understand it:
- Under IFRS 17, insurance companies are viewed as service providers. They provide a service and receive a contractually agreed margin for it, the so-called contractual service margin (CSM).
The CSM is initially recognized as a liability. It can be interpreted as the present value of future profits for future services. The realization presented in the income statement occurs according to the service provision in the future.
General approach: Building Block Approach
The Building Block Approach (BBA) is the essential part for the valuation of insurance obligations.
In this approach, the obligations are determined by means of fulfillment cash flows and the CSM is determined. The cash flows comprise expected, probability-weighted premiums, insurance benefits and costs.
The discounting takes into account the time value of money, the characteristics of the cash flow and the liquidity characteristics of the insurance contract.
A risk adjustment must be taken into account. This includes the amount of compensation that the insurer would require for bearing the uncertainty of the cash flows.
The CSM is the expected and to be earned profit of the insurance contract.
Balance sheet – simplified illustration
The balance sheet can be simplified as follows:
At the beginning of the insurance contract, no profit is shown. This will be realized in the future (deferral of profit in CSM). To reduce the volatility in the profit and loss account, certain buffers are provided. It is important to note that there are three methods with different approaches:
- Building Block Approach (BBA)
- Premium Allocation Approach (PAA)
- Variable Fee Approach (VFA)
The technical liabilities of a group of insurance contracts consist of two parts:
- LRC – Liability for remaining coverage: Fulfillment cash flows related to future services plus CSM (unearned profit) remaining
- LIC – Liability for incurred claims: Fulfillment cash flows for claims incurred, but not yet paid.
Income Statement – simplified illustrsation
In simplified form, the income statement is presented as follows.
- No gross premiums are shown.
- The reinsurance result is explicitly disclosed.
- Clear presentation of the result from the savings process.
- Presentation of the change in discount factors, if any.
The realized profits – income before taxes – are centrally determined by these factors (profit drivers):
- Realization of CSM and risk adjustments
- Experience variance: The differences between expected losses and costs and those actually determined.
- Differences between investment income according to IFRS 9 and interest expense on insurance liabilities
Generally, the following simplifications apply to the reporting of changes:
- Changes Financial risks: P&L or OCI
- Past or present services: P&L
- Future services: P&L (adjustment to CSM)
Premium Allocation Approach
The Premium Allocation Approach (PAA) is the preferred approach for non-life business.
Variable Fee Approach – VFA
The Variable Fee Approach (VFA) is the preferred option for life insurance business. It reduces the volatility in the net income of the income statement.