ifrs 17 - university of illinois 17_0.pdf · the iasb issued ifrs 17[1], a comprehensive new...

IFRS 17 A New Insurance Contract Accounting Approach

Prepared by: Zhe Huang, Wen-Chun Liu, Mengfei Wang, Yun Xia

Faculty: Klara Buysse

Department of Mathematics, College of Liberal Arts and Sciences,

University of Illinois at Urbana-Champaign

December 15, 2017

Abstract:

The IASB issued IFRS 17[1], a comprehensive new accounting standard for insurance contracts covering recognition and measurement, presentation and disclosure. Insurance companies need to adapt the IFRS 17 standards to his insurance contracts and financial statements before 1 January 2021. In this research, we looked into the IFRS 17 standards, developed a term life insurance contract model, and applied the IFRS 17 standards to this contract. Result suggested that the modification from IFRS 4 to IFRS 17 mainly focused on the following measurements:

a) Estimation of future cash flows; b) Discount rate; c) Risk adjustment for non-financial risk; d) Contractual service margin, and e) Subsequent measurement

Table of Content:

I. Introduction II. IFRS History and Background

2.1 IFRS Foundation and Background 2.2 Benefits of Reporting Under IFRS 17 2.3 Major Difference Between IFRS 17 and Solvency II

III. IFRS Interpretation 3.1 Scope and Feature 3.2 Measurement Models 3.3 Recognition 3.4 Estimate of Future Cash Flows 3.5 Discounting 3.6 Risk Adjustment for Non-Financial Risk 3.7 Contractual Service Margin

IV. IFRS Illustrative Example 4.1 Assumptions 4.2 Calculation 4.3 Accounting Illustration

V. Limitation and Future Research Implication VI. Appendix

I. Introduction IFRS is defined as International Financial Reporting Standards1. It is issued by the International Financial Reporting Standards Foundation (IFRS Foundation) and the International Accounting Standards Board (IASB). IFRS acts on entity accounts, and provides a global language to make accounts comparable and legible to different countries. Currently, countries report under IFRS reporting systems are using IFRS 4 for insurance contracts.

IASB issued the IFRS 17 standards on May 17, 2017. As a result of the change, insurance companies will need to comply with the IFRS 17 standards by January,1 2021. Many countries adopt IFRS as their official accounting standards, such as South Korea, European Union, Australia, Hong Kong. The United States does not adopt IFRS as accounting standards, but uses US GAAP for domestic accounting practices, while they do follow IFRS for companies with subsidiaries in other countries. By adapting IFRS 17, insurer will become truly comparable across most national boundaries, and will be more informed for portfolio choices. In this investigation, we evaluate the IFRS 17 Standard, apply it to a term insurance, and compare the results with the previous accounting practices. The goal is to understand the IFRS 17 standards and to build a small insurance company in order to discuss the effect of IFRS 17.

II. IFRS 17 Background

2.1 IFRS® Foundation and IFRS System The IFRS® Foundation is a non-profit international organization that is responsible for developing high quality, understandable, enforceable, and globally accepted accounting standards, known as IFRS Standards2. Before the establishing of IFRS® Foundation and the issue of IFRS Standards, insurance companies from different countries used independent and unstandardized accounting principles for financial reporting. IFRS® Foundation beliefs that “High-quality financial information is the lifeblood of capital markets”. By providing standardized accounting principles that companies should follow when preparing and publishing the financial statement, IFRS® provides a standardized way for companies to describe financial performance. Publicly accountable companies and financial institutions are legally required to publish their financial reports in accordance with the agreed accounting standards for some jurisdictions. IFRS® Foundation aims to bring transparency, accountability, and efficiency to financial markets around the world by developing the IFRS Standards. IFRS® Foundation serves the public interest by fostering trust, growth, and long-term financial stability in the global economy by enhancing international comparability, reducing the information gap between capital providers and investors, helping investors to identify opportunities and risks across the world3.

IFRS Standards have already been widely accepted around the world. According to the official website of IFRS (ifrs.org), IFRS Foundation have completed profiling for 150 jurisdictions, including all of the G20 jurisdictions. The total 150 jurisdictions represent all parts of the globe, 29% from Europe, 15% from Africa, 9% from the Middle East, 22% from Asia and Oceania, 25% from Americas. About 84% of the IFRS recorded profiles require IFRS Standards for all or most

1 “IFRS 17 Standards”. http://www.ifrs.org/issued-standards/list-of-standards/ifrs-17-insurance-contracts/ 2 “IFRS.org”. http://www.ifrs.org/about-us/who-we-are/ 3 “Why global accounting standards”. http://www.ifrs.org/use-around-the-world/why-global-accounting-standards/

domestic publically accountable entities in their capital market. The 150 profiled jurisdictions represent 98.6% of the world’s GDP (2015 data), and 47.5% of the profiled jurisdictions GDP require IFRS Standards for all or most domestic Publicly Accountable Entities (PAEs). IFRS Standards enhance the global comparability by providing standardized accounting principles. Even though United States still report under U.S. GAAP, some United State multination corporation has already used IFRS standards for their foreign subsidiaries4.

2.2 Benefits of Reporting under IFRS 17

Currently, jurisdictions that are reporting under IFRS Standards, apply IFRS 4 Insurance Contracts on insurance contracts. IFRS 4 is a standard issued in March 2004 by the International Accounting Standards Board (the Board). IFRS 4 applies to entities which have:

- insurance contracts (including reinsurance contracts) and reinsurance contracts (IFRS 4-2(a)); - financial instruments with a discretionary participation feature.

According to IFRS.org, IFRS 4 is an interim standard resulting from phase I of the Board’s active project on insurance contracts and is intended to apply only until the entities adopt IFRS 17. Currently, the lack of consistency in IFRS 4 leads to the situation that different countries are using different accounting practices. However, IFRS 17 requires that all insurance contract will have to use the same accounting treatment. This will be beneficial for the insured and the insurance company. Thus, IFRS 17 will increase the transparency and more comparability. IFRS 17 uses present value rather than historical cost to calculate insurance obligation. IFRS 17 will have a significant effect on financial, actuarial field. IFRS 17 is effective for annual reporting periods beginning on or after January,1 2021. Currently, IFRS 17 is not publically available. It is currently available only to ifrs.org Premium subscribers. The unaccompanied standard will be available to basic subscribers in early 2018. According to the ifrs.org, IFRS 17 combines current measurement of the future cash flows with the recognition of profit of the period that services are provided under the contract; presents insurance service results (including presentation of insurance revenue) separately from insurance finance income or expenses; and requires an entity to make an accounting policy choice of whether to recognize all insurance finance income or expenses in profit or loss or to recognize some of that income or expenses in other comprehensive income. IFRS 17 measurement model emphasis best estimate of future cash flows, time value of money(discounting), risk adjustment, and contractual service margin(CSM)5. More and more jurisdictions are adopting IFRS Standards as it is an internationalized standard that provides a consistent methodology in accounting and financial reporting. For countries that heavily involved in international markets trading, IFRS Standards provides a system with global comparability and saves time and money that gave to accounting. More than one third of modern economics rely on international transactions, and the international transactions' weight is expected to grow in the future. It is important to regulate the international trading, and provide a transparency environment for investors. Also, countries involved in international trading might lose profits due to different countries maintaining their own national accounting standards. In

4 “The use of IFRS Standards around the world”. http://www.ifrs.org/use-around-the-world/ 5 “IFRS 17 Insurance Contracts”. http://www.ifrs.org/issued-standards/list-of-standards/ifrs-17-insurance-contracts/

conclusion, it is necessary to set an international accounting standard to create a high quality, transparent, equitable calculation basis for different countries.

For investors, IFRS standards provide transparency by increasing the cross-countries comparability and having high quality of financial information. IFRS standards also provide equitable by using same calculation basis to reduce the difference between national accounting standards. Thus, they enhance the impartiality when investors judging opportunities and risk internationally. For entities, the IFRS can prove a credible globally accepted accounting language. IFRS reduces international reporting cost by unifying business transaction, thus improves market efficiency. The reason for which is, in the long run, that the single set of national accounting standards will waste time and consume more cost for preparing the international accounting reports. Using IFRS will reduce the preparing time and cost, and regulate the international trading.

IFRS 17 reduces reporting time by decreasing the number of companies that use the GAAP bases, and it reduces the reporting cycle by automation. IFRS 17 also increases the planning, estimate, and management quality and speed thus it can increase expanding speed for international markets. From the management side, IFRS 17 let insurance companies proactively manage the business by completing consistent reports for all entities, hence improves risk rating. Insurance companies can uniform internal reporting and external reporting by having these benefits.

As entities, using IFRS will better manage accounting and finance information at the same time. Entities will also measure itself with international peers on same accounting basis.

2.3 Major difference between IFRS 17 and Solvency II

Solvency II, is a formula-based law that regulates especially EU insurance companies. Solvency II came into force on January 1, 2016. As IFRS 17 will also be adopted by European countries. The IFRS 17 affects all insurance, reinsurance contract, and investment with discretionary participation features (only for companies issuing insurance contract). However, Solvency II affects all contracts regulated as insurance. When doing accounting contract components, IFRS 17 separate non-insurance components from insurance components, while Solvency II requires less separation due to its demand of market consistent valuation for all assets and liabilities. IFRS 17 and Solvency II provide two different Definition of Contract Boundary. IFRS 17 states that entities don't have rights to receive premiums or obligations to provide service, however, Solvency II states entities have the one-sided right to dissolution the contract.

The difference between IFRS 17 and Solvency II is that IFRS 17 provides less detailed information for the calculation. For example, cash flows in IFRS 17 would incur to fulfil a group of contracts, and Solvency II cash flow projection includes all cash inflows and cash outflows. Unlike Solvency II, IFRS 17 does not allow overhead cash flows. IFRS 17 requires entities discount the insurance liabilities by using top-down and bottom-up approach without specific rate. However, Solvency II unequivocal require yield curve to calculate the discounting, which published by the European Insurance and Occupational Pensions Authority (EIOPA). For the risk adjustment part, IFRS 17 required two main type of risk adjustment, which not provided a specific calculation. Under the Solvency II, entities calculating the risk margin aligns with the Cost of Capital method. However, entities have the potential to prefer another method under IFRS 17.

III. IFRS 17 Interpretation 3.1 Scope and Feature

IFRS 17 applies to: 3 (a) insurance contracts, including reinsurance contracts, it issues; (b) reinsurance contracts it holds; and (c) investment contracts with discretionary participation features it issues, provided the

entity also issues insurance contracts5.

IFRS 17 does not apply to: 7 (a) warranties provided by a manufacturer, dealer or retailer in connection with the sale

of its goods or services to a customer (see IFRS 15 Revenue from Contracts with Customers).

(b) employers’ assets and liabilities from employee benefit plans (see IAS 19 Employee Benefits and IFRS 2 Share-based Payment) and retirement benefit obligations reported by defined benefit retirement plans (see IAS 26 Accounting and Reporting by Retirement Benefit Plans).

(c) contractual rights or contractual obligations contingent on the future use of, or the right to use, a non-financial item (for example, some licence fees, royalties, variable and other contingent lease payments and similar items: see IFRS 15, IAS 38 Intangible Assets and IFRS 16 Leases).

(d) residual value guarantees provided by a manufacturer, dealer or retailer and a lessee’s residual value guarantees when they are embedded in a lease (see IFRS 15 and IFRS 16).

(e) financial guarantee contracts, unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts. The issuer shall choose to apply either IFRS 17 or IAS 32 Financial Instruments: Presentation, IFRS 7 Financial Instruments: Disclosures and IFRS 9 Financial Instruments to such financial guarantee contracts. The issuer may make that choice contract by contract, but the choice for each contract is irrevocable.

(f) contingent consideration payable or receivable in a business combination (see IFRS 3 Business Combinations).

(g) insurance contracts in which the entity is the policyholder, unless those contracts are reinsurance contracts held (see paragraph 3(b))5.

According to IFRS 17 Contract 8(a) to 8(c), Entity should apply IFRS 15 instead of IFRS 17 if: 8 (a) entity does not reflect an assessment of the risk with individual consumers; (b) providing services rather than making cash payments; (c) insurance risk transferred from consumer's use of services rather than cost of those

services5.

IFRS 17 aimed to show financial position and result for the reporting period, the scope includes recognition, measurement, presentation and disclosure of insurance liabilities. The Scope of IFRS 17 includes entities of insurance contract, reinsurance contract, and investment contract. With more information being disclosed in insurance companies’ financial statements, investors will be more informed on the characteristics, risk nature, amount, timing, and uncertainty of future cash flow from insurance contracts with in the scope of IFRS 17.

3.2 Measurement Models There are three measurement models used in IFRS 17. They are: General model (building block approach), variable fee approach (VFA) and premium allocation approach (PAA)6.

(Left to right: Building Block Approach, Premium Allocation Approach, Variable fee approach)

The general model, building block approach, is the default approach. It should be applied to all insurance contracts, unless they have direct participation feature, or eligible for PAA method. It usually applied on endowments, term life, whole life insurance. The technical provisions can be simply interpreted as four steps: estimate future cash flow, discount back to present value, adjust for the risk and calculate contractual service margin. The building block approach discounts cash flow with an allowance for risk, and consistently valued options and guarantees. It uses a discount rate reflects insurance contract cash flow characteristics. It recognizes profit and loss as a contractual service margin over the contract term. The variable fee approach applied on contracts directly linked to underlying assets, such as unit links and certain participating contracts. The technical provision of VFA is similar to Building Block Approach. After the initial recognition, VFA recognizes fair value of underlying assets, and measures shares of future value of underlying assets and fulfillment cash flows that do not vary on returns, and discount to present value. The following process of risk adjustment and contractual service margin process is the same as building block approach. Variable It is designed to deal with participating business where the liability is tied to underlying items. It reflects the link to underlying returns for contracts that participate in a clearly pool of underlying items, where policy holders are paid a substantial share of the returns and a substantial proportion of the cash flows vary with the underlying terms. This approach cannot measure reinsurance contracts. Under this method, the adjustments to the CSM use current discount rate. Notably that changes in insurers’ share of assets recognized in CSM, and the profit or loss movement in liabilities mirrors treatment on underlying assets.

The premium allocation method is an optional method that used on short term contracts and pre-claim period, such as 1-year non-life, health insurance, short-term group contracts. It is an optional simplified model that allowed for contracts that have a short duration. It is able to be applied to 6“Indepth,alookatcurrentfinancialreportingissues.”PwC

measure the pre-claims liability, and the building block approach is applied for measuring incurred claims.

3.3 Recognition According to IFRS 17 standard, an entity should recognize a group of insurance contract from the earliest date of the following:

(a) the beginning of the coverage period of the group of contracts;(b) the date when the first payment from a policyholder in the group becomes due; and(c) for a group of onerous contracts, when the group becomes onerous5.

The carrying amount of insurance contracts can be express as:

Fulfillment cash flow ± Contractual Service Margin(CSM),

this equation can be furthermore express as

(Discount (Estimate of Future Cash Flow) ± Risk Adjustment) ± CSM

with the first two terms combined equal to Fulfillment cash flow

3.4 Estimate of Future Cash Flows

There are several principles entities should have followed when they are estimate the future cash flows. First, they should consider all reasonable information and apply probability-weighed mean of all possible outcomes to calculate the estimates of future cash flows. For example, if the premium is $100, but the probability the policyholder will pay the premium is only 40%, then the estimate future cash flow is $40.Second, the estimated of market variables should be consistence with their observable market price. The market variables are variables that can be observe from market, for example, interest rate. As a result, the estimated of interest rate the entity use when estimating future cash flow should be consistence with observable market interest rate price.Furthermore, the estimate of future cash flows also should be current and explicit. The former one implies the estimate should reflect existing conditions and latest assumptions about the future at each measurement date while the latter one means the estimate should separately from the adjustment for the time value of money and financial risk.Besides, there are two levels of aggregation. The entity can either estimate the future cash flow individually for each insurance contract, or aggregately for some insurance contracts first then allocate to individual contract, if the insurance contracts are subject to similar risks, for example contracts within a product line, and are not issued more than one year apart from each other. However, entities should always follow paragraph 16 when they are determining insurance contracts portfolio:

16 An entity shall divide a portfolio of insurance contracts issued into a minimum of: (a) a group of contracts that are onerous at initial recognition, if any; (b) a group of contracts that at initial recognition have no significant possibility of becoming onerous subsequently, if any; and (c) a group of the remaining contracts in the portfolio, if any5.

If the future cash flow is estimated individually, according to paragraph 34, the entity should only consider the cash flow resulted from the rights that they can forced the policyholder to pay the premium or from the obligations that the entity has to provide service. That is to say, the invest income and cash flow raised from reinsurance contracts should not be included.

3.5 Discounting

Discount an adjustment that converts future cash inflows and outflows into the present value. An entity shall use discount rates on measure the fulfillment cash flows to adjust the carrying amount of the liability, and the amount of the insurance finance income or expense included in profit or loss that entity chooses to disaggregate insurance finance income or expenses between profit or loss. General insurers feel that an allowance for illiquidity in the IFRS 17 discount rate is appropriate in some cases, especially for long tail liabilities. Because that provide a more realistic valuation of insurance liabilities (IFRS 17 insurance contracts, section B72).

Discount rates (paragraphs B72–B85)

36 An entity shall adjust the estimates of future cash flows to reflect the time value of money and the financial risks related to those cash flows, to the extent that the financial risks are not included in the estimates of cash flows. The discount rates applied to the estimates of the future cash flows described in paragraph 33 shall:

(a) reflect the time value of money, the characteristics of the cash flows and the liquidity characteristics of the insurance contracts;

(b) be consistent with observable current market prices (if any) for financial instruments with cash flows whose characteristics are consistent with those of the insurance contracts, in terms of, for example, timing, currency and liquidity; and

(c) exclude the effect of factors that influence such observable market prices but do not affect the future cash flows of the insurance contracts5.

IFRS 17 Standard introduce the idea of discount rate to insurance accounting to reflect the time value of money and the financial risk like liquidity risk that related to those entities. The discount rate is required to reflect the time value of money, the liquidity characteristic of insurance contracts, and the characteristics of the cash flow like maturity and duration. It should also be consistent with observable current market rate or return for financial instrument with cash flows that have similar characteristics with those of the insurance contracts in terms of timing, liquidity, maturity and duration. It should also exclude the factors that influence the observable market rate of return like credit risk, but do not affect the future cash flows of the insurance contracts.

B84 In principle, for cash flows of insurance contracts that do not vary based on the returns of the assets in the reference portfolio, there should be a single illiquid risk-free yield curve that eliminates all uncertainty about the amount and timing of cash flows. However, in practice the top-down approach and the bottom-up approach may result in different yield curves, even in the same currency. This is because of the inherent limitations in estimating the adjustments made under each approach, and the possible lack of an adjustment for different liquidity characteristics in the top-down approach. An entity is not required to reconcile the discount rate determined under its chosen approach with the discount rate that would have been determined under the other approach5.

From the IFRS 17 Standards, the discounting process deals with two kind of cash flows. Insurance cash flows not directly related to assets and insurance cash flows directly related to assets. To

discount the insurance cash flows that are not directly linked to assets, IFRS 17 suggested two approaches:

- Bottom-up - Top-down approach

B74(b) Cash flows that very based on the returns on any financial underlying items shall be discounted using rates that reflect the variability; or adjusted for the effect of that variability and discounted at a rate that reflects the adjustment made5.

The bottom-up approach firstly determines a risk-free yield curve in appropriate currency, then adjusts for liquidity premium of the insurance contract comparing to similar financial instrument publically available in the market. The liquidity premium adjustment reflects the risk that insurance contracts holds the liquidity of cash flow is not fixed due to policyholders may terminate contract and only subject to surrender penalties, or cannot terminate contract at all.

The top-down approach uses a yield curve that reflects the current market rate of return implicit in a fair value measurement of a reference portfolio of assets, while adjusted to eliminate cost of risk taken that are not relevant to the insurance contracts, which is not relevant for insurance contract. It usually uses market rate of return of a reference portfolio of assets minus default adjustment minus cost of downgrade. It adjusts the effect of variability and reflects in discount rate7. There are three types of liability cash flows. One is not-liquid liabilities, for example, annuities and single premium terms. Not-liquid liabilities has no surrender risk and only risks are longevity risk and expense risk, and the premiums have been paid. The Bottom-up approach to calculate not-liquid liabilities is the swap yield curve plus the liquidity premium. Second is the Semi-liquid liabilities, for example, endowments and terms. It has some surrender risk, other liquidity indicators include mortality, longevity, morbidity, expense risk, and premium is not all paid. The bottom-up approach need to adjust the interest rate with swap yield curve plus some portion of the liquidity premium. The last kind of liabilities is liquid liabilities like unit links that has substantial surrender risk and no longevity risk. The Bottom up approach need to use the swap yield curve appropriate to the currency of the related cash flows. All these kinds of liabilities can find discount

7“IntroductiontoIFRS17.”3Blocks,http://www.3blocks.co/documents/materials/3Blocks_IFRS%2017.pdf

rate by top-down approach by using government bonds curve less credit risk like probability of default and cost of downgrade.

In practice, the top-down approach and the bottom-up approach may result in different yield curves. The inherent limitation in estimating the adjustments made under each approach, and the possible lack of adjustment for different liquidity characteristics in different approach can be the cause of the differences.

3.6 Risk Adjustment for Non-Financial Risk Risk adjustment for non-financial risk is the risk other than financial risk in insurance contracts. Financial risk has already been considered in the estimate of future cash flows and discounting. The financial risk and non-financial risk should be separated, and the entity should not count them twice in the risk adjustment process. Risk adjustment is necessary because of uncertainty. For example, an entity has its own life table based on its historical data, but the data may not be exactly correct for the product since the mortality table is only a prediction. The policyholders may live shorter or longer than expected, which places mortality risk and longevity risk on the entity. Risk adjustment makes sure that the entity is able to afford these risks if they happen.

The risk adjustment for non-financial risk measures the compensation required to make the entity indifferent between fulfilling a liability that has multiple possible outcomes and a liability that will generate fixed cash flows. For example, if the entity has a liability of $110, and another liability that has a 50% probability to be $100 and a 50% probability to be $120, the compensations for these two liabilities must be the same. As a result, the risk adjustment for non-financial risk gives the information about how much the insurer charges for the uncertainty of future cash flows. It also reflects the degree of diversification and risk aversion.There are two main types of risk adjustment. First, insurance contracts need to be adjusted to compensate for bearing the uncertainty about the amount and timing of the cash flows that arises from non-financial risk. Second, reinsurance contracts held also need to be adjusted to represent

the risk being transferred by the holder of the group of reinsurance contracts to the issuer of those contracts. In the balance sheet, both assets and liabilities will be adjusted.

Under IFRS 17, risk adjustment is also the discounted cost of capital at risk free rate. However, IFRS 17 does not specify the method to calculate the risk-adjustment for non-financial risk, but it sets some requirements for risk adjustment:

• Risks with low frequency and high severity needs a higher risk adjustment than risks with high frequency and low severity.

• Risks with a longer duration will result in a higher risk adjustment than risks with a shorter duration.

• Risks with a larger volatility needs a higher risk adjustment than risks with a lower volatility. Risk adjustment has to be higher for less known information about current estimate.

An entity should apply judgement when measuring the risk adjustment for non-financial risk. It is also important for the entity to provide concise and informative disclosure when applying the judgement so that the users of financial statements can compare the performance of the entity with the performance of other companies.

3.7 Contractual Service Margin Contractual service margin (CSM) is used to present an expected profit for the insurance contracts in the future. IFRS 17 Insurance Contracts states the CSM is "a component of the carrying amount of the asset or liability for a group of insurance contracts representing the unearned profit the entity will recognise as it provides services under the insurance contracts in the group"8. The contract also points out the CSM indicate recognized profit or loss. CSM indicates the amount available to provide for overhead expenses and profit. For a profitable contract the CSM is not negative at the beginning or at subsequent periods (when eliminated, it can be reinstated). The reason for CSM may not be negative is because, the initial CSM equals to the negative sum of best estimate liability and risk adjustment. The sum of the are less than zero. Thus, provides us that the CSM must be greater than zero (for profitable contracts). The entity shall adjust the CSM to make future cash flows be favorable or unfavorable by using unlocking method.

8IFRS17Contractpg39AppendixA

The fulfilment cash flows diagram is for Building Block Method (General Method). The future cash flow estimate, discounting, and risk adjustment are fulfilment cash flows. The fulfilment cash flows indicate the present value of future cash flows after risk adjustment. For examples, it can be insurance premium, compensation expenses, etc. When net cash flows lead to CSM equal to zero, the insurance company should confirm the loss immediately.

The Contractual Service Margin (CSM) represents the profitable estimate of a contract over the coverage period. CSM can be influenced under different models. There are three measurement models, such as General Model, variable fee approach (VFA), and premium allocation approach (PAA). The VFA is applied to the insurance contract with direct participation features.

B101 Insurance contracts with direct participation features are insurance contracts that are substantially investment-related service contracts under which an entity promises an investment return based on underlying items. Hence, they are defined as insurance contracts for which: (a) the contractual terms specify that the policyholder participates in a share of a clearly identified pool of underlying items (see paragraphs B105–B106); (b) the entity expects to pay to the policyholder an amount equal to a substantial share of the fair value returns on the underlying items (see paragraph B107); and (c) the entity expects a substantial proportion of any change in the amounts to be paid to the policyholder to vary with the change in fair value of the underlying items (see paragraph B107 )5.

Under the VFA model, CSM is using current discount rate, since the total liability is adjusted According to the IFRS 17 contract, under the VFA model, entities also need to pay the policyholder the amount that equal to the fair value of the underlying items and a variable fee. Under the VFA model, CSM is using current discount rate, since the total liability is adjusted. According to the IFRS 17 contract, under the VFA model, entities also need to pay the policyholder the amount that equal to the fair value of the underlying items and a variable fee.

B104 The conditions in paragraph B101 ensure that insurance contracts with direct participation features are contracts under which the entity’s obligation to the policyholder is the net of: (a) the obligation to pay the policyholder an amount equal to the fair value of the underlying items; and (b) a variable fee (see paragraphs B110–B118) that the entity will deduct from (a) in exchange for the future service provided by the insurance contract, comprising:

(i) the entity’s share of the fair value of the underlying items; less (ii) fulfilment cash flows that do not vary based on the returns on underlying items5.

The General model is applied to the insurance contract without direct participation features or the insurance contract with participation features which fail the variable fee scope test. Under the General model, allocation CSM is using locked-in rate(accreting CSM with invariant discount rate)9. Applying the general model, entities need to measure an insurance contract including the total of the fulfillment cash flows and the contractual service margin, namely, CSM. The CSM is a measurement that cover the effective period of insurance contracts, which is a procedural variable.

9EFRAG“IFRS17InsuranceContractIllustrativeexampleoftheVariableFeeApproach”

Variable fee approach is a modification of general model that adds in the consideration of entities’ fair value changes to the CSM. Hence, the fair value changes shift from a measurement at occurrence to a measurement over a period, more specifically the remaining period of the contract. Consequently, this additional measurement represents the essential difference, in calculation, between the general model and variable fee approach. The significance of such measurement is tightly connected with the CSM since this is where the modification emerges.

Another method is Premium allocation method (PAA), used on short term contracts over one year of less. PAA is a simplified version that resembles a reasonable approximation to the General model. It incorporates the liability for the remaining coverage, namely, the prior period of an insured event, and a liability for incurred claims. The liability for incurred claims refers to the measurement from the occurred point of insured event. One key element that draws difference between PAA and two previous methods is the engagement of CSM. CSM is recognized over the coverage period, but PAA only focuses on present values that has nothing to with the whole contractual period. Thus, it is reasonable to conclude that CSM is not as significant here as in the general model or variable fee approach.

IV. Illustrative Example

4.1 Assumptions The following example illustrates how to initially recognize an insurance contract. The illustration is established on the following assumptions:

1. The company issues a universal life product that will mature after 50 years; 2. Yearly premium is $100 and will be paid at the beginning of each period; 3. All expenses will be paid at the end of each period; 4. The guaranteed interest rate is set at 3%; 5. The mortality rate is based on the Life table for the total population of United States in

2014; 6. The initial age is 25; 7. The risk adjustment is calculated using the same way as Solvency II; 8. The discount rate is calculated using the bottom-up approach; 9. One of the products has no death benefit, and the contract is not onerous. The other contract

has a death benefit of $20,000, and this contract becomes onerous. 4.2 Calculation

4.2.1 Discounting IFRS 17 Standards suggest two methods to calculate the discount rate: Bottom-up approach and Top-down approach. In the following illustrative example, we use the Bottom-up approach. The Bottom-up approach suggests that the discount rate equals to the risk-free interest rate plus the liquidity premium.

Discountrate = Interestrate012345066 + 𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦𝑝𝑟𝑒𝑚𝑖𝑢𝑚

We use the United States risk-free interest rate term structure in September 201710, released by the European Insurance and Occupational Pensions Authority (EIOPA), as our risk-free rate. We set the first 50 observations to draw the interest curve since the maturity of the insurance contract is 50 years. The liquidity premium represents the value that the insurer needs to compensate the policyholders because of the illiquidity of the insurance contracts. There are various ways to calculate liquidity premium, and we use one of the methods introduced by the Society of Actuaries (SOA)11, which suggests that the liquidity premium can be measured as the difference between the credited rate on the insurance contract and the risk-free rate. Since the 3% interest rate is guaranteed for 50 years, we use the guaranteed interest rate, 3%, minus the risk-free rate in Year 50, 2.374%, and get a liquidity premium of 0.626%. We add the liquidity premium to every single risk-free rate to get our bottom-up approach interest rates (See Appendix A).

Using these Bottom-up interest rates, we calculate the discount factor (See Appendix A) and the forward rate (See Appendix A) for each year with the following formulas:

𝐷𝐹(F) = 1

(1 + 𝑟(F))F

𝑟5I0JK0L =(1 + 𝑟 F )F

(1 + 𝑟(F4M))F4M− 1

10 “Risk-Free Interest Rate Term Structures”. https://eiopa.europa.eu/regulation-supervision/insurance/solvency-ii-technical-information/risk-free-interest-rate-term-structures/ 11 “Calculating Liquidity Premiums for Insurance Contracts”. http://www.soa.org/library/newsletters/financial-reporter/2010/september/frn-2010-iss82-reback.pdf/

0.0%

1.0%

2.0%

3.0%

4.0%

0 10 20 30 40 50

Interest Curve

Risk-freeRate Bottom-upApproach

liquidi

4.2.2 Estimate of Future Cash Flow

With the bottom-up discount factors and forward rates, we calculate the present value of cash flow by discounting the cash flow of each year back to time 0. The best estimate of cash flow can be calculated by compounding the sum of the present value of the future cash flows with the bottom-up interest rate (See Appendix B and Appendix C).

4.2.3 Risk Adjustment Risk adjustment, or risk margin, is the discounted cost of capital at the risk-free rate. IFRS 17 sets some requirements for risk adjustment but does not give a specific method to calculate it. We decide to use Solvency II with some modification so it can meet the requirements of IFRS 17.

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Solvency II covers both financial risk and non-financial risk. However, this part of risk adjustment excludes financial risk, so we just consider mortality risk and longevity risk because they are the only two non-financial risks under our assumptions. Mortality risk is the risk that people live shorter than predicted, and longevity risk is the risk that people live longer than expected.

The mortality table we use is the United States Life Table for the Total Population in 2014 (See Appendix D), published by the National Vital Statistics System (NCHS). To simulate these situations, we adjust the mortality table by 25%, both upward and downward, and get two new mortality tables (See Appendix E). For the product with a death benefit, we first calculate the liability cash flows for each year with regular mortality rate. We use the bottom-up discount factor to discount them back to time 0 and sum them up to get the present value of the liability cash flow, which is also the best estimate of liability cash flow at time 0. Then we calculate the best estimate of liability cash flow for each year with the following formula:

𝐵𝐸 F = 𝐵𝐸(F4M) ∙ 𝑟5I0JK0L R − 𝐶𝐹(F)

After that, we apply the same method with shocked mortality rates to calculate the present values of liability cash flow. We find that the present value of liability cash flow for increased mortality rate is higher than that for regular mortality rate, and the difference between these two values is the mortality risk. The present value of liability cash flow for decreased mortality rate is lower than that for regular mortality rate, so there is no longevity risk for this product. Under Solvency II, the correlation coefficient between mortality and longevity is given as -0.25, and we use the following formula to get the mortality Solvency Capital Requirements (SCR) at time 012:

𝑆𝐶𝑅V156 = 𝐶𝑜𝑟𝑟𝑁𝐿(1,Z) ∙ 𝑆𝐶𝑅1 ∙ 𝑆𝐶𝑅Z1,Z

Now we have the mortality SCR at time 0 and the best estimate (BE) of liability cash flow for each year, and we can use the proportional method to calculate the mortality SCR for each year13:

𝑆𝐶𝑅 F = (𝑆𝐶𝑅([)𝐵𝐸\6F([)

) ∙ 𝐵𝐸\6F(F)

Finally, we calculate the risk margin with the following formula:

𝑅𝑖𝑠𝑘𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐶𝑜𝐶 ∙𝑆𝐶𝑅(F)

(1 + 𝑟 FcM )FcM

d

Fe[

12 “Solvency II”. http://ec.europa.eu/internal_market/insurance/docs/solvency/solvency2/delegated/141010-delegated-act-solvency-2_en.pdf/ 13 “Risk Margin in the S2”. http://www.actuaria.cz/upload/Risk_margin.pdf/

* CoC: cost of capital. Under Solvency II, cost of capital shall be assumed to be 6%; * r(t+1): the spot rate at the end of the year. Under Solvency II, the interest rate shall be the risk-free interest rate. However, using bottom-up interest rate is acceptable under IFRS 17, so we decide to use bottom-up rate here.

The risk margin is calculated as 825.31 for the product with death benefit. For the product without death benefit, we apply the same technique used on the product with death benefit except that their death benefits are different, and the risk margin is 298.43.

With the best estimate of cash flows, discounting, and risk adjustment, we can apply contractual service margin (CSM) to the products, which will be the next step of our research.

4.3 Accounting Illustration

The initial recognition for the two contracts is as follow: (In 1(a), the universal life product does not have death benefit. In 1(b), the product has a death benefit of $20,000.)

1(a)

Without maturity benefit 1(b) Maturity benefit $20,000

Estimates of the present value of future cash inflows (2,660) (2,660) Estimates of the present value of future cash outflows 3,221 4,561 Estimates of the present value of future cash flows 561 1,902 Risk adjustments for non-financial risk 298 825

Fulfilment cash flows 859 2,727 CSM 0 0 Insurance contract (Assets)/ Liability on initial recognition 859 2,727

1. Noted that future cash inflows are express in negative number, so a positive total future cash flows indicates estimated inflows is smaller than outflows and the contract is onerous.

2. According to IFRS17 paragraph 47, once the contract become onerous, the insurance company should recognize a loss in profit immediately, leading the amount of liability being equal to the amount of future cash flows.

3. According to IFRS Standards Illustrative Example, the effect on profit is as follow: 1(a)

Without maturity benefit 1(b)

Maturity benefit $20,000 Insurance service expenses (859) (2,727) Loss in this year (859) (2,727)

V. Limitation and Future Research Implication

In this research, we applied the IFRS 17 Standard to a whole life insurance contract. Our research gives a brief illustration on how IFRS 17 Standard will affect the insurance accounting

methodology. An entity will be quantitatively analyzed about its exposure to insurance risks and financial risks like liquidity risk, market risk, and credit risk. Insurance risk is the likelihood that the insured event will occur and require the insurer to pay a claim, it is the risk associated with insurance policy, the premium set up, and risk mitigation by reinsurance. It is the risk every policy holds. Apart from insurance, entity should also suggest quantitative information about its exposure to financial risk such as market risk, credit risk, and liquidity risk. However, our research holds the limit that, due to the lack of calculation instruction of IFRS 17 Standard, our illustration is based on our interpretation and limited to only one kind of measurement models, general model. Also, IFRS 17 only give text interpretation, while a lot of calculation methodologies are not clearly defined for the data.

As the IFRS 17 Standards gave no formula, the interpretation from different companies may vary from each other. Future research can focus on the decision making of discount rates, impact on IFRS 17 on different types of insurance products, the measurement difference between IFRS 17 and US GAAP, and income statement format.

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Appendix D – Mortality Table

Appendix E – Shocked Mortality Table

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ifrs 17 - university of illinois 17_0.pdf · the iasb issued ifrs 17[1], a comprehensive new...

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