Applying the General Measurement Model in IFRS 17 Insurance Contracts – the impacts of changes in assumptions on onerous contracts
In this Accounting Alert article, we take a closer look at how contracts that are expected to be unprofitable when written (i.e., onerous on initial recognition) would be accounted for over time, particularly if the assumptions underlying the contracts change. This follows on from the April 2022 edition of Accounting Alert, where we considered the accounting implications of initially recognising onerous insurance contracts under the General Measurement Model in IFRS 17.
How are onerous insurance contracts initially accounted for?
As discussed in the April 2022 edition, an insurance contract is classified as onerous at the date of its initial recognition. This is if at that date the sum of the following items result in a net outflow:
- The fulfilment cash flows allocated to the contract
- Any previously recognised insurance acquisition cash flows arising from the contract
- Any cash flows arising from the contract at the date of initial recognition.
When a portfolio of insurance contracts includes onerous contracts, apart from in some limited circumstances, IFRS 17 requires:
- The onerous contracts to be identified by being grouped and accounted for separately to profitable contracts in the same portfolio
- The entity issuing the onerous contracts to recognise an immediate loss in respect to groups of onerous contracts. This may result in the issuer recognising a loss in respect to the onerous insurance contracts before the coverage period commences, or before the first premium due from the policyholder is paid.
In the July 2021 edition of Accounting Alert, we discussed the concept of the ‘unit of account’ as it applies under IFRS 17. In the July 2021 article we noted that IFRS 17 requires insurance contracts to be accounted for on a portfolio basis. In addition, to prevent ‘offsetting’ within portfolios, IFRS 17 requires entities to account for portfolios of onerous contracts separately from other portfolios of insurance contracts that are expected to be profitable.
IFRS 17 permits entities to further subdivide insurance contracts that are identified to be onerous at initial recognition into ‘sub-portfolios’ of onerous contracts with similar characteristics. This is provided that the entity has internal reporting systems that supply information on the extent to which each of the sub-portfolios is onerous.
How are onerous insurance contracts subsequently accounted for?
The example provided in the April 2022 edition demonstrates that the contractual service margin attributable to onerous insurance contracts on initial recognition is set to zero. It also demonstrated that the estimated net outflows attributable to onerous insurance contracts is recognised as a liability for remaining coverage (LRC).
Similar to requirements for the contractual service margin to be released to insurance revenue over the term of an insurance contract, IFRS 17 requires the initial loss, and any subsequent changes in the loss component arising from onerous insurance contracts, to be allocated on a systematic basis over the remaining coverage period of the contracts (and therefore to profit or loss). However, under IFRS 17 any subsequent changes in the fulfilment cash flows attributable to onerous contracts - both positive and negative - are allocated on a systematic basis between:
- The loss component of the LRC
- The LRC, excluding the loss component.
Subsequent changes in the fulfilment cash flows attributable to onerous contracts - both positive and negative - arguably reflect both the:
- Inaccuracies in the initial estimates of the loss component
- Losses that were not apparent at the point of initial recognition of the onerous contracts. This includes losses that have arisen subsequent to initial recognition of the onerous contracts, as a consequence of factors not anticipated at that time.
IFRS 17 does not prescribe any methods for systematically allocating subsequent changes in the fulfilment cash flows attributable to onerous contracts between the loss component and the LRC, excluding the loss component. As with any allocation methodology, the method adopted by an entity will not change the ultimate profitability (or otherwise) of the insurance contracts it issues. However, it can impact the timing of the recognition of losses (or profits) arising from onerous insurance contracts over the coverage period.
In some circumstances, a portfolio of insurance contracts initially recognised as onerous can subsequently become profitable. In such circumstances, the loss component is reversed and a contractual service margin (CSM) would be attributed to the portfolio. Accordingly, any CSM attributed to onerous contracts subsequent to initial recognition would be released to insurance revenue over the remaining coverage period of the contracts. This is consistent with the example provided in the November 2021 edition of Accounting Alert.
Example
To demonstrate the implications of the foregoing discussion on onerous contracts under IFRS 17, we assume the following fact pattern:
BDO Pet Insurance Ltd has written 100 3-year insurance policies to commence on 1 July 2022.
The policies insure the holder for up to 50% of any eligible veterinarian bills they incur in respect to their pets during the coverage period.
Each holder of a policy is required to pay an annual $65 premium, payable on the first day of each year of the coverage period.
For the purposes of measuring the insurance contracts under IFRS 17, and based on past experience with similar types of insurance policies, BDO Pet Insurance Ltd adopts the following assumptions:
- Expected annual cash outflows are $7,000 per annum
- All insurance claims incurred during a year will be paid at the end of the year
- No policies will lapse during the coverage period, and no extension periods are offered under the policy
- Discount rate of 5% per annum
- BDO Pet Insurance Ltd is not exposed to any material financial risk in respect to insurance policies
- The risk adjustment for non-financial risk is measured at 5% of the present value of expected cash outflows
- BDO Pet Insurance Ltd incurs no initial acquisition costs in respect to insurance policies.
Based on these assumptions, BDO Pet Insurance Ltd measures the portfolio of onerous contracts on initial recognition as follows:
| $ | |
| Estimate of the present value of future cash inflows | 18,586 |
| Estimate of the present value of future cash outflows | 19,063 |
| Estimate of the present value of future (net) cash flows | (477) |
| Risk adjustment for non-financial risk | (953) |
| Fulfillment cash flows | (1,430) |
| Contractual service margin | 0 |
| Insurance contract asset/(liability) on initial recognition | (1,430) |
| Loss recognised on initial recognition of insurance contract liability | 1,430 |
As demonstrated above, the fulfilment cash flows attributable on initial recognition to the insurance policies issued by BDO Pet Insurance Ltd are expected to produce net cash outflows to the entity. Accordingly, BDO Pet Insurance Ltd will:
- Set the contractual service margin for the portfolio of onerous insurance contracts to zero
- Recognise a loss equal to the fulfilment cash flows, which comprises the estimate of the present value of future (net) cash flows and the estimated risk adjustment for non-financial risk.
If BDO Pet Insurance Ltd’s assumptions at the commencement of the onerous insurance contracts hold for the first year of the coverage period, the entity would measure the insurance contracts in the first year as follows:
| Year ended 30 June 2023 | Estimates of present value of future cash flows ($) | Risk adjustment for non-financial risk ($) | Contractual service margin ($) | Insurance contract liability ($) |
| Opening balance (asset)/liability | 0 | 0 | 0 | 0 |
| Changes related to future service - new insurance contracts | 477 | 953 | 0 | 1,430 |
| Cash inflows | 6,500 | _ | _ | 6,500 |
| Insurance finance expenses | 953 | 48 | _ | 1,001 |
| Insurance finance income | (604) | _ | _ | (604) |
| Changes related to current service | 0 | (398) | _ | (398) |
| Cash outflows | (7,000) | _ | _ | (7,000) |
| Closing balance – (asset)/liability | 326 | 603 | 0 | 929 |
As BDO Pet Insurance Ltd’s assumptions at the commencement of the onerous insurance contracts hold for the first year of the coverage period, there are no deviations from the expected fulfilment cash flows arising from the contracts. Accordingly, BDO Pet Insurance Ltd has nothing to allocate between:
- The loss component of the LRC
- The LRC, excluding the loss component.
• Expected claims payments of $7,500
• Estimated risk adjustment to 6% of the present value of the insurance liability. As actual claims payments differed from what BDO Pet Insurance Ltd had originally anticipated, the entity allocated the change in cash flows between the original loss component and the LRC, excluding the loss component on a 50%/50% basis.
Consistent with their experiences and assumption changes, BDO Pet Insurance Ltd measured the portfolio of onerous insurance contracts as follows:
| Year ended 30 June 2024 | Estimates of present value of future cash flows ($) | Risk adjustment for non-financial risk ($) | Contractual service margin ($) | Insurance contract liability ($) |
| Opening balance (asset)/liability | 326 | 603 | 0 | 929 |
| Cash inflows | 6,500 | _ | _ | 6,500 |
| Insurance finance expenses | 651 | 30 | _ | 681 |
| Insurance finance income | (310) | _ | _ | (310) |
| Changes related to current service | 400 | (380) | _ | 20 |
| Changes related to future service | 876 | 175 | _ | 1,051 |
| Cash outflows | (7,800) | _ | _ | (7,800) |
| Closing balance – (asset)/liability | 643 | 428 | 0 | 1,071 |
In the third year of the coverage period of the onerous insurance contracts, BDO Pet Insurance Ltd paid $6,800 in claims (as compared to the expected $7,500).
Consistent with their experiences, BDO Pet Insurance Ltd would measure the portfolio of onerous insurance contracts as follows:
| Year ended 30 June 2025 | Estimates of present value of future cash flows ($) | Risk adjustment for non-financial risk ($) | Contractual service margin ($) | Insurance contract liability ($) |
| Opening balance (asset)/liability | 643 | 428 | 0 | 1,071 |
| Cash inflows | 6,500 | _ | _ | 6,500 |
| Insurance finance expenses | 357 | 22 | _ | 379 |
| Insurance finance income | _ | _ | _ | 0 |
| Changes related to current service | (700) | (450) | _ | (1,150) |
| Cash outflows | (6,800) | _ | _ | (6,800) |
| Closing balance – (asset)/liability | 0 | 0 | 0 | 0 |
In this example, the negative change in fulfilment cash flows experience in year 2 resulted in 50% of the change being allocated to the LRC in the following year. As the claims experience in year 3 were less than what was expected at the end of year 2, BDO Pet Insurance Limited would treat the corresponding reduction in the LRC in year 3 as a reduction in insurance service expenses for that period, rather than as insurance services revenue. This is consistent with the notion that the allocated cash flows relate to the estimated loss on the contracts on initial recognition.
Coming up
In a future edition of Accounting Alert, we will consider the Premium Allocation method for measuring insurance contracts under IFRS 17.
For more on the above, please contact your local BDO representative.
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