What is IFRS 17?
IFRS 17 Insurance Contracts sets out the accounting requirements for insurance contracts, including reinsurance contracts held. Under IFRS 17, a reinsurance contract held is accounted for as a standalone contract, independent of the accounting for the underlying insurance contracts.
For many entities, IFRS 17 represents a significant change. Common existing practice is to account for reinsurance contracts held using a ‘mirroring approach’, essentially matching reinsurance contract revenue, costs, assets and liabilities to the underlying insurance contracts.
In determining IFRS 17, however, it was decided that separate accounting is necessary to truly reflect the economics of an entity’s rights and obligations under insurance contracts it issues and reinsurance contracts it holds. The primary insurer is obligated to pay the full amount of the claims to the policyholder under the insurance contract, irrespective of whether the reinsurer is obliged to perform or able to meet its obligations.
Thus, the performance risks for reinsurance contracts held differ from those for underlying insurance contracts even when their terms and cash flows are identical.
In addition, few reinsurance contracts have terms and cash flows that are identical to the terms and cash flows of the underlying contracts, making separate accounting even more relevant.
IFRS 17 includes requirements specific to reinsurance contracts held to reflect the fact that the contracts are held rather than issued.
In terms of recognition of items, IFRS 17 introduces two key terms: contractual service margin and fulfilment cashflows.
The contractual service margin is calculated at the start of the contract as the difference between the present value of the expected cashflows (plus a risk adjustment) and the present value of expected premiums. In its simplest form, the contractual service margin represents the overall profit expected on the insurance contract.
The fulfilment cashflows represent the estimate of the present value of the future cash outflows less the present value of the future cash inflows that will arise as the entity fulfils the contract.
A key principle of IFRS 17 is that no gains are recognised when the contract starts because the entity has not yet satisfied any of its performance obligations. Instead, the contractual service margin is recognised as the entity satisfies the performance obligation.
Worked example: The timing of gains recognition
Imagine an entity receives $900 in premiums at the start of an insurance contract spanning 3 years. It calculates the expected cash outflows to have a present value of $600 ($200 each year), giving a contractual service margin (expected profit) of $300.
In year 1, the entity would record $300 in insurance revenue and $200 for incurred claims. As the entity has received $900 but recorded only $300 in revenue, the remaining $600 will be held as a liability.
This represents and must be disclosed as the fulfilment cashflows of $400 (to be incurred at $200 a year) and the remaining contractual service margin of $200 (the remaining unearned profit).
The liability will decrease to $300 at the end of year 2 as $200 fulfilment costs are incurred and a further $100 contractual service margin is earned; and it will be repeated in year 3.
IFRS 17 is effective for periods beginning on or after 1 January 2021.
Sources: ICAEW | IFRS.org | ACCAglobal.com
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