IFRS 17 Insurance Contracts

IFRS 17 was issued by the IASB in May 2017, amended in June 2020, and is mandatory for annual periods beginning on or after January 1, 2023. It replaced IFRS 4, an interim standard that let each country keep using its local practices, which made it almost impossible to compare insurers across markets.

The standard measures each group of contracts as the sum of two building blocks. Fulfilment cash flows are the present value of expected future cash flows plus an explicit adjustment for non-financial risk. The contractual service margin (CSM) is the unearned profit that will be recognized as insurance service is provided. If the group is onerous, the loss is recognized immediately.

For the actuary, IFRS 17 demands work that goes beyond reserve valuation: segmenting portfolios, projecting cash flows by cohort, setting discount rates, calibrating the risk adjustment, defining coverage units and explaining every movement in the period. The IAA's International Standard of Actuarial Practice ISAP 4 addresses precisely this work (see standards).

IFRS 17 applies to contracts that transfer significant insurance risk, regardless of who issues them, to reinsurance contracts issued and held, and to investment contracts with discretionary participation features issued by entities that also issue insurance contracts. Before measurement, non-insurance components are separated out: embedded derivatives, distinct investment components and distinct goods or services.

The unit of account is the group. Portfolios are formed first: contracts with similar risks that are managed together. Each portfolio is divided into at least three groups based on profitability at initial recognition: onerous, no significant possibility of becoming onerous, and the rest. In addition, contracts issued more than one year apart cannot be combined in a group, which gives rise to annual cohorts. This rule prevents profits on profitable contracts from offsetting losses on onerous contracts issued at a different time.

A group is recognized at the earliest of the start of the coverage period, the date the first payment from a policyholder becomes due and, for onerous groups, the date the group becomes onerous. Insurance acquisition cash flows paid before that date are recognized as an asset and allocated to the corresponding groups.

The general model, called the building block approach (BBA) in the drafts and the general measurement model (GMM) in practice, builds the liability from four pieces: unbiased, probability-weighted expected future cash flows; discounting that reflects the time value of money and the liquidity characteristics of the cash flows; a risk adjustment for non-financial risk; and the CSM. Cash flows must be current estimates, consistent with observable market prices, and must capture the full range of scenarios, not just the most likely one.

The total liability is split into the liability for remaining coverage (LRC), which relates to future service, and the liability for incurred claims (LIC), which relates to events that have already occurred. The LIC is measured with fulfilment cash flows only; the CSM always belongs to the LRC.

For discounting, IFRS 17 allows two routes: the bottom-up approach, which starts from the liquid risk-free curve and adds an illiquidity premium, and the top-down approach, which starts from the yield on a reference portfolio and removes the components that are not relevant, such as expected and unexpected credit risk. Under the general model, interest is accreted on the CSM at the rate locked in at initial recognition, while the cash flows are remeasured at current rates.

The CSM is a balance that absorbs changes in estimates relating to future service. If expected mortality on a life portfolio improves, the present value of outflows falls and the CSM rises, but the effect is not recognized all at once: it is spread over the remaining years of coverage. If an adverse change exhausts the CSM, the excess is recognized as a loss and the group acquires a loss component. By contrast, changes relating to past or current service, such as the difference between expected and actual claims for the year, go straight to profit or loss.

Coverage units measure the quantity of service provided in each period and are based on the quantity of benefits and the expected duration of coverage. In term life insurance they are typically the expected sum insured in force, which declines through lapses and mortality; in a life annuity, the expected annuity payment; in contracts with investment services, they may combine insurance coverage with the fund management service.

The risk adjustment (RA) is the compensation the entity requires for bearing the uncertainty about the amount and timing of cash flows that arises from non-financial risk. IFRS 17 does not prescribe a method: practitioners use percentiles (VaR or TVaR) of the cash flow distribution, cost of capital or explicit margins in the assumptions. What it does require is disclosure of the equivalent confidence level, which allows comparison between entities that use different techniques. The entity may present the entire change in the RA in the insurance service result or disaggregate its finance effect.

Contracts with direct participation features promise the policyholder a substantial share of the return on a clearly identified pool of underlying items, such as an investment fund or a portfolio of assets. For these contracts IFRS 17 requires the variable fee approach (VFA). Eligibility is assessed at inception: the policyholder participates in a share of identified items, the entity expects to pay a substantial share of their fair value, and a substantial proportion of the change in the payments varies with that fair value.

The economic idea is that the entity earns a variable fee: its share of the value of the underlying items less the cash flows that do not vary with them. That is why, under the VFA, changes in the entity's share of the fair value of the underlying items, including financial effects, adjust the CSM instead of going to profit or loss. There is no accretion at a locked-in rate: the CSM is implicitly measured at current rates.

A typical case is life insurance with an investment component, where the policyholder's account balance tracks a fund and the insurer charges management fees and risk charges. Under the general model, market volatility would flow through profit or loss; under the VFA it is absorbed in the CSM, which better reflects the business model. The entity may apply the risk mitigation option when it uses derivatives or reinsurance to hedge the contract's financial risks.

The PAA is an optional simplification for measuring the liability for remaining coverage. It is eligible if the coverage period of each contract in the group is one year or less, or if the entity reasonably expects the result not to differ materially from the general model. That is why it is used by almost all annual property, auto and medical expense portfolios.

Under the PAA, the LRC works like an unearned premium: premiums received less acquisition cash flows, less the amount already recognized as revenue. If coverage is one year or less, acquisition cash flows may be expensed as incurred. There is no explicit CSM, but the onerous contract test still applies when facts and circumstances indicate that the group is onerous, in which case a loss component is recognized.

The PAA does not simplify the liability for incurred claims: the LIC is measured with fulfilment cash flows, that is, a discounted best estimate plus a risk adjustment. If claims are expected to be paid within one year, discounting may be omitted. Triangle techniques, Chain Ladder and Bornhuetter-Ferguson remain fully relevant here.

An onerous group has a loss component that is recognized in profit or loss. Thereafter, releases of cash flows from the LRC are allocated systematically between the loss component and the remainder, so as not to recognize revenue for services already recognized as a loss. For reinsurance held, the 2020 amendments added the loss recovery component: if a reinsurance contract covers onerous underlying contracts, the entity recognizes a gain that offsets part of the loss.

The income statement separates the insurance service result (insurance revenue less insurance service expenses) from insurance finance income and expenses. Insurance revenue excludes investment components, which are not service: a savings premium that will be returned is not revenue. The entity may present part of the effect of changes in interest rates in other comprehensive income to reduce mismatches with its assets.

Transition requires the full retrospective approach, as if IFRS 17 had always been applied. If that is impracticable for a group, the entity chooses between the modified retrospective approach, which uses permitted approximations, and the fair value approach, under which the CSM is the difference between the fair value of the group under IFRS 13 and its fulfilment cash flows. That choice determined how much future profit ended up in the opening CSM of many life insurers.

Mexican insurance companies do not prepare their regulatory financial statements under IFRS 17. They apply the CNSF accounting framework set out in Annex 22.1.2 of the CUSF (Single Insurance and Surety Circular): its special criteria for insurance and surety operations, and the NIF (Mexican Financial Reporting Standards) issued by CINIF for matters not covered, with supplementary application under NIF A-8 only when there is no CNSF criterion or applicable NIF, and without contravening the Commission's criteria. This is how even insurers listed on the BMV (Mexican Stock Exchange) report, such as GNP, whose consolidated statements are prepared under the CNSF accounting framework. At the time of writing we have not identified any published provision adopting IFRS 17 for regulatory financial statements.

Technical reserves under the LISF (Insurance and Surety Institutions Law) already use concepts close to IFRS 17: a best estimate of future cash flows discounted with market curves and a risk margin calculated with a 10% cost of capital on the RCS (Chapter 5.4 of the CUSF). The fundamental difference is that the CNSF regime has no contractual service margin and no grouping by profitability and annual cohort; the pattern of profit recognition depends on the rules for recording premiums, acquisition costs and reserves, and differs from that of IFRS 17.

IFRS 17 is nonetheless present in the Mexican market. Subsidiaries of groups that consolidate under IFRS, such as many of the large European insurance groups, prepare IFRS 17 reporting packages for their parent, which means running the regulatory valuation and the international accounting valuation in parallel. It also applies to non-insurance entities that report under IFRS and issue contracts that transfer significant insurance risk. This has created demand for actuaries who master both frameworks and can reconcile LISF reserves with fulfilment cash flows and the CSM.