What Is IFRS 17? Explaining the Key Components
Understand IFRS 17, the new global standard for insurance accounting. Learn how it transforms financial reporting for transparency and comparability.
IFRS 17 is an accounting standard for insurance contracts, effective January 1, 2023, replacing IFRS 4. It enhances transparency and comparability by establishing consistent principles for recognition, measurement, presentation, and disclosure. Previously, IFRS 4 allowed varied accounting practices, hindering comparisons. IFRS 17 addresses this with a single, principles-based model, ensuring financial statements accurately represent the financial position, performance, and cash flows of entities issuing insurance contracts.
Scope and Applicability
IFRS 17 applies to all entities issuing insurance contracts, including reinsurance. This extends beyond traditional insurers to any entity undertaking significant insurance risk, such as reinsurers or manufacturers offering qualifying warranties. It also covers investment contracts with discretionary participation features if the entity issues insurance contracts.
An “insurance contract” under IFRS 17 is defined as one where an issuer accepts significant insurance risk from a policyholder, agreeing to compensate them if an uncertain future event adversely affects them. This emphasizes the transfer of significant insurance risk, distinct from financial risk.
For example, property and life insurance policies are insurance contracts due to risk transfer. The standard applies to both new and existing contracts, requiring companies to update accounting policies and systems.
Certain contracts are excluded from IFRS 17’s scope, including product warranties where the manufacturer is directly liable, employer pension plans, and some financial guarantee contracts. It also does not apply to insurance contracts where the company is the policyholder, except for reinsurance contracts held.
Core Measurement Models
IFRS 17 introduces a current measurement model for insurance contract liabilities, re-measured at each reporting date using updated estimates. This provides a transparent view of a company’s financial position and risk exposure. The standard outlines three models: the General Measurement Model (GMM), the Premium Allocation Approach (PAA), and the Variable Fee Approach (VFA).
The GMM is the default for most insurance contracts, especially those over one year. It calculates liability as the sum of Fulfillment Cash Flows (FCF), a Risk Adjustment (RA), and the Contractual Service Margin (CSM). GMM requires continuous re-estimation of future cash flows and unwinding of discount rates.
The PAA simplifies the GMM for short-duration contracts, like property, casualty, or health insurance with annual renewals. Entities can use PAA if the coverage period is one year or less, or if the liability measurement would not materially differ from GMM. This approach recognizes the liability for remaining coverage as premiums received less acquisition costs.
The VFA is for insurance contracts with direct participation features, such as unit-linked or participating contracts where policyholders share in investment performance. Unlike GMM, VFA adjusts the Contractual Service Margin for changes in the entity’s share of underlying item fair value, aligning profit recognition with services provided.
Key Building Blocks of Measurement
Measurement of insurance contract liabilities under IFRS 17, especially within the General Measurement Model, relies on three building blocks. These components provide a comprehensive view of future obligations and expected profits.
Fulfillment Cash Flows (FCF) are the explicit, unbiased, and probability-weighted estimate of the present value of future cash inflows minus outflows expected as the entity fulfills its contracts. These include premiums, claims, and expenses. FCF are discounted using current market rates reflecting contract cash flow characteristics, emphasizing observable market data.
The Risk Adjustment (RA) is an explicit component representing compensation for bearing non-financial risk uncertainty in insurance contracts. This accounts for uncertainty in future cash flow amounts and timing. IFRS 17 mandates an explicit RA calculation. Methods like confidence level techniques or cost of capital approaches can determine RA.
The Contractual Service Margin (CSM) represents unearned profit expected over the insurance contract’s life. It is recognized as revenue over the coverage period as services are provided, not upfront. CSM adjusts for future cash flow changes and absorbs initial losses or gains, preventing profit recognition at inception unless the contract is onerous. An onerous contract, where FCF and RA indicate a loss, has its expected loss recognized immediately.
Financial Statement Presentation
IFRS 17 changes how insurance items are presented in financial statements, aiming for greater transparency and consistency. It introduces new liability categories on the statement of financial position and alters revenue and expense recognition in the income statement, providing more relevant information to assess an insurer’s financial performance.
On the statement of financial position, new liability categories are “Liability for Remaining Coverage” (LRC) and “Liability for Incurred Claims” (LIC). LRC represents the entity’s obligation for future services under insurance contracts, including fulfillment cash flows and the remaining contractual service margin. LIC represents obligations for claims that have occurred but are unpaid. Reinsurance assets are also presented separately.
In the statement of financial performance, insurance revenue is recognized based on services provided over the reporting period, derived from the contractual service margin and other components, differing from prior premium-based models. Insurance service expenses, including claims incurred and changes in fulfillment cash flows and risk adjustment, are also presented separately.
Changes in the discount rate and unwinding of the discount on insurance liabilities are recognized separately as insurance finance income or expenses. Entities can choose to recognize all insurance finance income or expenses in profit or loss, or disaggregate amounts between profit or loss and Other Comprehensive Income (OCI). This option helps reduce accounting mismatches with invested assets. IFRS 17 also mandates extensive disclosure requirements for judgments, assumptions, and sensitivities underlying insurance contract measurement.