How to assess the value of insurance contract liabilities IFRS 17.
The International Financial Reporting Standard 17 (IFRS 17) specifies three models for calculating the value of insurance contract liabilities:
General Measurement Model (GMM) is the most commonly used approach, based on the Building Block Approach (BBA). It divides the Fulfillment Cash Flows, which include the Risk Adjustment, and ends with the Contractual Service Margin (CSM).
Premium Allocation Approach (PAA) is a method that is similar to recognizing Unearned Premium Reserves (UPR). It is typically used for riders of life insurance companies and non-life insurance contracts.
Variable Fee Approach (VFA) is specific and applies to insurance contracts that include dividends, Unit Linked or Universal Life, that meet specified conditions. In Thailand, only Unit Linked meets the conditions and can use this approach. (Further reasons can be found under the section “Can Universal Life and Unit Linked insurance use the General Measurement Model (GMM) approach?”)
In the early drafts of IFRS 17, there was a method called the Building Block Approach (BBA), which involves segmenting various components, similar to stacking bricks in layers. Later on, this approach was set as a general standard method and called a new name, the General Measurement Model (GMM), which can be applied to general insurance contracts universally.
The key components of the General Measurement Model (GMM)
Fulfillment Cash Flows is like the cost of an insurance contract, which the obligation to pay out average cash flows over various future periods. The simple calculation steps are as follows:
Estimate Future Cash Flows using actuarial assumptions to make the best estimate assumption, considering factors such as morbidity rates, mortality rates, lapse rates, and expenses.
Add the Risk Adjustment for Non-financial Risk to reflect potential risks and deviations from the best estimate assumptions. The calculation accounts for variability, ensuring that the average cash flow will be sufficient to meet obligations even during periods of volatility. This principle is similar to Risk-Based Capital (RBC), which requires setting aside a Provision for Adverse Deviation (PAD), a concept familiar to many. Examples of non-financial risk assumptions that need to be provisioned include morbidity rates, mortality rates, lapse rates, and expenses.
Use the cash flows derived from the best estimate assumptions and the Risk Adjustment for Non-Financial Risk to calculate the present value by applying the discount rate.
Contractual Service Margin (CSM) is also known as Expected Contract Profit. T
he calculation of CSM involves finding the difference between the following two values:
The present value of estimated average cash flows to paid obligations, where these obligations are estimated as if all premiums received in the future will have no profit at all and will be used to pay the obligations of the policy.
The present value of estimated cash outgo of Fulfillment Cash Flows. When taking the difference in present value between "Debt intended to have no profit" are subtracted with "Debt from Best Estimate + Risk Margin," and will be obtained the "Expected Profit" in the form of Contractual Service Margin (CSM).
This means that for policies sold on the inception date, a shortcut method can be used to calculate the Contractual Service Margin (CSM) by taking it directly from the present value of Fulfillment Cash Flows. This is because profitable policies will have a negative present value of Fulfillment Cash Flows (similar to Risk Based Capital (RBC) where Gross Premium Valuation in the first year can be negative for non-loss policies), and that negative value can be directly representing the Contractual Service Margin (CSM).
When using the General Measurement Model (GMM) and time passes, how will accounting entries be recorded?
The Contractual Service Margin (CSM) will gradually recognized profit by releasing it. The release of the CSM value will reduce the CSM, and the reduced portion will be recognized as profit in the profit and loss statement. The CSM is recorded as a liability because it represents unrecognized profit. Additionally, the CSM value must be compared with the balance sheet. There have been cases that CSM value was too high, causing equity to turn negative. In such cases, the CSM must be constrained to prevent negative equity.
Future Cash Flows from actuarial assumptions based on the best estimate assumption and the Risk Adjustment for Non-Financial Risk are divided into considerations of the past/present and the future, as follows:
When there are changes in the estimated average cash flows related to past and present services, these should be directly reflected in the profit and loss statement.
If the changes are related to future services, most of it will be added to or deducted from the Contractual Service Margin (CSM). In cases where losses exceed the CSM and it is insufficient, the remaining amount will impact on the profit and loss statement, indicating that the insurance contract has become onerous. These losses must be recorded and recognized in the profit and loss statement immediately.
The discount rate in IFRS 17 is intended to reflect both the risk-free rate and the illiquidity premium of the insurance contract. The discount rate can be determined using either a Top-Down Approach or a Bottom-Up Approach.
The Top-Down Approach can be derived by taking the portfolio yield and subtracting the credit risk. This means the discount rate = portfolio yield - credit risk.
The Bottom-Up Approach can be derived by adding the risk-free rate to the illiquidity premium directly. This means the discount rate = risk free rate + liquidity risk and Portfolio Yield = Risk Free Rate + Liquidity Risk + Credit Risk.
The important aspect that IFRS 17 addresses and improves upon from IFRS 4 is the effort to ensure that insurance contracts with similar cash flow estimates can be valued the same. Under the current IFRS 4, this is not possible because IFRS 4 allows companies to use their own investment return rates as discount rates, which can result in inequality in accounting.
IFRS 17 also allows the segmentation of fulfilment cash flows into those that varying fulfilment cash flows, such as expected surrender outgo or death benefit outgo linked to the account value of unit-linked products.
Another type of cash flow is the non-varying fulfilment cash flows, such as general cash flows for paying life insurance benefits from traditional insurance policies or medical expenses from health riders. These cash flows remain unchanged regardless of changes in financial risks or variables.
In principle, varying fulfilment cash flows and non-varying fulfilment cash flows can use different discount rates to reflect the type of these cash flows. Non-varying fulfilment cash flows typically use only the risk-free rate, while varying fulfilment cash flows use a higher discount rate that includes financial risk.
However, if separate discount rates are not preferred, IFRS 17 allows the use of a single set of cash flows and a risk-neutral discount rate.
When understanding the steps to find the discount rate, let's consider how to apply the results. The interest yield can be divided into two parts:
Insurance Finance Expense at Locked-in Discount Rate: Actuaries typically set this rate to ensure that policy reserves grow at a specific interest rate (unwind) each year. Generally, this rate is calculated when designing the insurance product. In IFRS 4, this might be called the Valuation Interest Rate or sometimes the Target Profit Rate. This interest rate is set during the insurance product design phase with the intention that this insurance policy must invest to achieve the anticipated profit. This interest rate is considered one of the insurance businesses that must ensure the funds grow as expected.
Investment Return > Locked-in Rate: Any excess from the previously mentioned rate can be considered an investment margin. This excess can be accounted for in the Insurance Investment Result on the income statement.
Do non-life insurances require to assess using the General Measurement Model (GMM) only?
Financial reporting under TFRS 17 offers more flexibility than many understand. While most non-life insurance involves short-duration contracts, this does not necessarily mean that the General Measurement Model (GMM) must always be applied exclusively.
One alternative approach presented is the Premium Allocation Approach (PAA), which can be utilized for short-duration insurance contracts, particularly when the contract term does not exceed one year or when the results from PAA do not significantly differ from GMM. The allowance for PAA aligns with the intent of TFRS 17 to reflect the characteristics of actual insurance contracts and enables companies to adopt a simpler method for liability calculation.
PAA is similar to the calculation of Unearned Premium Reserve (UPR) used in the Risk-Based Capital (RBC) framework, focusing on recognizing unearned premiums for the remaining contract duration, which is a familiar method for non-life insurance companies. This familiarity makes the transition to PAA under TFRS 17 relatively straightforward.
Although most non-life insurance companies sell short-duration contracts, there are circumstances where the use of PAA may be insufficient, such as:
If long-term claim payments (exceeding one year) are anticipated.
If liability reserve estimates need to consider the impact of time factors and discounting.
In these cases, companies must utilize the GMM, which is more complex, as it requires forecasting future cash flows and accurately recognizing changes in liabilities, necessitating reserves to be maintained differently from the previous system.
In the realm of insurance reserving and financial reporting according to international standards, the focus is not on whether a business operates as a life insurance or non-life insurance company based on its license. Instead, it hinges on the nature of the contracts, determining whether they are classified as long-duration or short-duration insurance contracts. Notably, life insurance companies can sell short-duration insurance contracts and utilize the Premium Allocation Approach (PAA), while non-life insurance companies can also offer long-duration contracts, such as cancer insurance.
What should be done when starting to calculate and perform for the first time?
Some people might wonder, since the principles of IFRS 17 have changed so significantly, what should be done on the first day of implementing IFRS 17? How should the calculations be made, especially regarding the Contractual Service Margin (CSM) that needs to be embedded with each policy?
When the insurance company has already sold policies, suddenly valuing these insurance contracts along with the Contractual Service Margin (CSM) under IFRS 17. It is akin to retrospectively looking back as the first day of selling the policy and then bringing that valuation forward to the present time.
This first method is called the Full Retrospective Approach (FRA). In practice, it likely has not retained all the historical data, making the method difficult to implement. Therefore, IFRS 17 allows using estimations from the past with estimated variables (without needing actual historical data). This second method is called the Modified Retrospective Approach (MRA).
This method is similar to when life insurance companies want to change the method of calculating policyholder dividends and reevaluates what it will be. It must be retrospectively studied from the past to the present for each policy. Sometimes, estimations from the past are used with estimated variables. Therefore, it is like a modified version of the Full Retrospective Approach (FRA).
That's good news! If we prefer not to use the Full Retrospective Approach (FRA), we can use the prospective approach. This third method, called the Fair Value Approach (FVA), involves calculating the Contractual Service Margin (CSM) from fair value subtracted by the current value of Fulfilment Cash Flows. Details can be studied from the General Measurement Model (GMM) calculation method of IFRS 17, as mentioned earlier.
The frightening realities that must be considered…
In IFRS 17, there's one point that's different from before: there are no Balancing Items, or a category labeled "Others" in the disclosure notes anymore. This means that when calculating the numbers are not perfect, there won't be a catch-all category to put. Which can be considered a significant issue for those at the operational level, because anyone who has calculated and reconciled knows that there can be small differences that don't materially impact the totals, even if the variance is as slight as 0.1%.
Therefore, we will have to wait and see where this will be reported if it cannot be reconciled. It is advisable to consult or inform the auditors early on regarding this matter.
Can Universal Life and Unit Linked insurance use the General Measurement Model (GMM) approach?
The answer is that there is another calculation method available for companies selling these types of insurance. This method is called the Variable Fee Approach (VFA), which is similar in principle to the General Measurement Model (GMM) but includes additional features related to Participating Contracts. In the case of participating products in life insurance, despite the similar name, the contents do not yet have mechanisms to tie in dividend payment formulas (or another way to put it, true profit sharing is not yet established). Therefore, the General Measurement Model (GMM) must still be used. Only Universal Life and Unit Linked policies can be calculated using this method. If the conditions mentioned above and met there are clearly segregated asset funds, Universal Life policies currently sold in Thailand still do not have clearly separated asset funds, it cannot utilize the Variable Fee Approach (VFA).
When the change happens, will people understand?
This is something that cannot be overlooked. The financial statements of insurance businesses will change significantly with the adoption of IFRS 17, potentially causing confusion or misinterpretation among those familiar with the old standards, especially those who do not fully understand IFRS 17 yet. Therefore, before implementing IFRS 17, it is necessary to prepare investors, business owners, employees, policyholders, and the media to understand what will change. Even though it may seem complex and difficult to understand at first, IFRS 17 will clearly separate underwriting from investment considerations. It also redefines the recognition of revenue/fees (no longer insurance premiums), allowing life insurance and non-life insurance to be compared with each other and with other industries. Additionally, it is important to understand how profits and losses will be recognized asymmetrically. The key principles of Onerous Contracts (when there is a loss) and Contractual Service Margin (CSM) (when there is a profit).
One noticeable change after adopting IFRS 17 will be the significant drop in revenue recognition for life insurance premiums, now it will be treated like fees (life insurance premiums can no longer be recognized as revenue). For non-life insurance businesses, there will also be changes in revenue recognition and the breakdown of financial statements into more complex items. Many people may misunderstand that the insurance business is revenue has decreased, potentially causing stock market volatility if investors do not understand IFRS 17. Especially, with this misunderstanding will particularly affect endowment insurance products sold through banks, as they will no longer be recognized. For example, a premium of 100,000 baht might be recognized as revenue of only 1,000-baht fee.
For life insurance businesses, the recognition of profits and losses will be different. If there is a loss, it must be fully recognized immediately, but if there is a profit, it must be gradually recognized until the contract period. This means that IFRS 17 will slow down profit recognition for life insurance companies compared to the previous standards. However, many people misunderstand that IFRS 17 will reduce profits, which is not true.
Additionally, TFRS 17 will enable insurance businesses to recognize profits more consistently (smooth profit) and avoid the volatility experienced under TFRS 4
To reiterate, IFRS 17 should not reduce the profit recognition of life insurance and non-life insurance businesses. Only life insurance businesses will recognize profits more slowly (the profit pattern will change annually). However, the total profit will remain the same under both the old (IFRS 4) or the new (IFRS 17) standards.
With IFRS 17 in place, is RBC still necessary?
We shouldn't confuse IFRS 17 (International Financial Reporting Standard 17) with RBC (Risk Based Capital) because their objectives are entirely different. IFRS 17 is a financial reporting standard used for financial statements, impacting the profit and loss statement, balance sheet, and notes to the financial statements. On the other hand, RBC is a calculation of future solvency, commonly referred to as the Solvency Ratio. Specifically for RBC, it is known as the Capital Adequacy Ratio (CAR). The RBC calculation focuses primarily on the balance sheet. IFRS 17 aims to reflect the company's performance in the financial statements, while RBC aims to reflect the company's ability to meet its obligations (having funds to pay benefits to policyholders).
The outcome of IFRS 17 is financial statements in accordance with international accounting standards, whereas the result of RBC is the Capital Adequacy Ratio (CAR) according to the Life Insurance Act and the Non-Life Insurance Act.
The main working group for IFRS 17 consists of members from the Federation of Accounting Professions. In contrast, the main working group for RBC is from the OIC. However, the OIC is not complacent and is also setting up a working group to study the impact of IFRS 17.
Although the objectives of IFRS 17 and RBC are entirely different, both are widely used measures globally to provide stakeholders with different perspectives. Accountants, actuaries, and related experts need to study and apply these standards to their organizations and industry, ensuring sustainable growth with a platform that will soon transform the insurance business.
Similarities and Differences between IFRS 17 and VoNB/VIF
VoNB (Value of New Business) and VIF (Value of Inforce) are familiar terms in both the life insurance and non-life insurance businesses, especially when assessing a company's stock price or business value, particularly during mergers and acquisitions.
Contractual Service Margin (CSM) at the inception of the policy issuance is comparable to the Value of New Business (VoNB).
Contractual Service Margin (CSM) over time after the policy issuance is comparable to the Value of Inforce (VIF). By CSM looks retrospectively from the past to the present, while VIF is a prospective measure looking from the future back to the present.
This distinction highlights that the CSM in IFRS 17 may reduce the importance of VoNB/VIF calculations. Consequently, the Key Performance Indicators (KPIs) of insurance companies are likely to shift from using VoNB/VIF to use the CSM of IFRS 17.
Conclusion
The International Financial Reporting Standard 17 (IFRS 17) for insurance contracts significantly impacts the classification, measurement, presentation, and disclosure of information for both life and non-life insurance businesses. This standard requires cooperation from many departments, such as actuarial science, accounting, and investment. Recognizing its importance, many entities within the insurance industry have been actively preparing and equipping themselves with knowledge to comply with IFRS 17. They have been working diligently to implement IFRS 17 effectively, ensuring that it brings the maximum benefit to the industry.
From reading IFRS 17, The Key Transformations in the Insurance Business are as follows.
The method of revenue recognition changes from premiums to service fees.
The method of profit/loss recognition from inception is asymmetrical. When there is a loss (Onerous Contract), it is recognized immediately, while gradual recognition of profits (Contractual Service Margin).
The method of recognizing profits/losses subsequently after day one requires keeping record of profits/losses until contract eventually ends due to asymmetry in recognizing in each side.
Profit will be defined in detail by separating into Underwriting Performance and Investment Performance.
The calculation of insurance contract reserves under the Building Block Approach (BBA), referred to as the General Measurement Model (GMM) in IFRS 17, includes specific methods such as the Premium Allocation Approach (PAA), commonly used in non-life insurance businesses, and the Variable Fee Approach (VFA), used by life insurance companies selling Universal Life (with clearly segregated asset funds, which currently do not meet the criteria in Thailand) or Unit Linked products must be used.
One thing to emphasize again is that while this standard changes the way revenue/income is recognized, it does not change the total profit. What will change be in the recognition of profit pattern/profit emergence each year, which may lead to a slower recognition over time.
And perhaps most importantly for preparing for IFRS 17, it's about preparing the data, systems, processes, and indispensably, ensuring that personnel, management, and even general investors. They say whoever grasps IFRS 17 can retire sooner because the more you study it, the more you realize how complex it is, and the more you just want to retire early.
In conclusion, as the former president of the Society of Actuaries of Thailand, I believe that implementing IFRS 17 will make financial statements more transparent, easier to understand, and more comparable with other industries, benefiting all parties. Specifically, it will enhance the credibility of insurance companies' financial statements. However, the implementation and cost of preparing financial reports in line with international standards will require detailed planning and appropriate execution. This includes preparing personnel, educating related experts, changing roles and responsibilities in various departments. Especially for actuaries, whose roles will change significantly. Additionally, the readiness of actuarial models, software systems, operational systems, and integration with existing systems in insurance companies must be ensured. Only then can the benefits to industry and the public be maximized, with controlled costs and timelines. This will truly be beneficial for all parties involved.
Written by Master Tommy (Pichet)
FSA, FIA, FRM, FSAT, MBA, MScFE (Hons), B.Eng (Hons)
All rights reserved for the content of this article. Do not use it for any commercial gain. In addition to receiving permission from ABS company only.
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