General model

The main measurement approach consists of a current Fulfilment Value, which is a risk-adjusted valuation of the cost, from the perspective of the insurer, of fulfilling all insurance obligations.

The objective is to have individual contracts as unit of account, but aggregation is allowed provided that it matches with this objective.

Contractual Service Margin

The goal of this margin is to avoid the recognition of all future profits at inception of the contract.

Instead, the contractual service margin is released as insurance services are provided and is adjusted when the best estimate cash flows for the future are revised.

Risk Adjustment

A risk adjustment must be added as a compensation for the uncertainty inherent in the fulfilment cash flows.

An insurer can choose a method that best fits with its own view on risk compensation—for example as used in pricing, but should report the corresponding quantile to make a comparison possible (“Confidence Level Equivalent”).

Best Estimate

The best estimate should reflect the mean value of the expected cash flows required to fulfill all contract obligations. This includes premiums, claim benefits, administration expenses and directly attributable overhead expenses, but excludes indirect overhead expenses.

These cash flows must be discounted by using a discount rate (curve) that is consistent with the characteristics of the insurance liabilities and observable market prices.

Special cases

Onerous contracts: A negative contractual service margin is not allowed. Future Losses must be recognised immediately. If the situation improves in the future, then firstly all losses must be reversed before a positive margin can be booked.

Short-term liabilities: For short-term liabilities (usually a coverage period of 12 months or less), the unearned premium is considered as a reasonable approximation (“Premium Allocation Approach”). This waives the use of separate building blocks and of discounting.

Reinsurance contracts: Insurance liabilities should be measured gross of reinsurance and reinsurance contracts held by insurers (as cedant) should be presented separately by using the same General Model approach. Unlike the General Model approach, however, the CSM for reinsurance contracts can be positive or negative.

Directly participating contracts: For contracts that participate directly in the return on underlying items, a modification of the General Model is used as the CSM requires more flexibility to adjust for the variability of the fee the insurance entity is earning (“Variable Fee Approach”).

Framework differences

The proposed measurement is similar, but not identical, to MCEV and Solvency 2 measurement.

Differences could include treatment of overhead expenses, choice of discount rate, risk adjustment methodology, contract boundaries, grouping and fair value approach for in-force business.

Income Statement Overview

The proposed fulfilment value is a current value measurement that requires updating at each reporting date, using actual contract information, actuarial assumptions and economic parameters such as the discount rate.

The difference between two consecutive reporting dates can have various sources. The allocation of the differences arising from each source depends on the nature of the source.

Roll forward (passage of time)

Moving one period forward implies that a part of the Contractual Service Margin and Risk Adjustment can be released in P&L, proportionate to the services provided and change in risk during the period.

Additionally, there is the time value of money where the discount rate is being unwound over the entire period. This unwind is released in P&L.

Sources

• Roll forward (passage of time)

Ways of recognition

• Profit or Loss (P&L)
• Other comprehensive income (OCI)

Cash flows of the previous period

When cash flows occur as expected, they form together with the released Contractual Service Margin and Risk Adjustment the insurance contract revenue of that period.

• In practice however, actual cash outflows will differ from the best estimate. This difference then leads to an “experience adjustment” in P&L.
• Also, there can be a portion of premiums received that is expected to be paidback to the policyholder regardless of whether an insured event occurs. This “investment component” is to be separated from the insurance premium and to be considered as a deposit and not as income.
• If premiums or deposit cash flows are different to expected, then it is plausible that this has a corresponding effect on expected future cash flows. For this reason, experience adjustments on these items are reflected in CSM (together with the related change in future cash flows).

Sources

• Cash flows of the previous period

Ways of recognition

• Update of the Contractual Service Margin
• Profit or Loss (P&L)
• Disclosure only

Change of discount rate

As the Fulfilment Value is a current value measurement, the discount rate must be updated every reporting period. Especially for long term liabilities, this can mean an enormous shift in the current value.

The IASB has therefore decided to allow insurers to split the effect of discounting in the income statement. Under the General Model, the effect of discounting can be split into:

1. The effect of passage of time; for this, the discount rate at inception of the contract is locked in and the effect is reported under P&L
2. The actual movement of the discount rate; to minimise accounting mismatches with financial instruments, insurance entities have the option to present this under either P&L or Other Comprehensive Income.

Sources

• Change of discount rate

Ways of recognition

• Profit or loss (P&L)
• Other comprehensive income (OCI)

Changed expectations for future cash flows

Updates of the actuarial assumptions underlying the applied cash flow projections will lead to new best estimates and/or risk adjustment.

As far as these updates relate to future coverage and other future services, these changes can be absorbed by adjusting the contractual service margin.

If this margin falls to zero, however, the remaining adverse changes should immediately be taken in P&L. For an onerous contract, previous losses must be unwound in the P&L before a positive Contractual Service Margin can be created again.

Sources

• Changed expectations for future cash flows

Ways of recognition

• Update of the contractual service margin
• Profit or loss (P&L)

New business

New business must be added each period according to the General Model Approach, Premium Allocation Approach or Variable Fee Approach. This adds to the existing contractual service margin or creates an immediate loss for onerous contracts.

On top of that, additional benefits from a contract modification should be recognized as a new contract. This would then create multiple premium components and (where the VFA does not apply) multiple locked-in discount rates within one contract.

Note that the total positive contribution in the year to CSM from new business needs to be shown separately in the disclosures,so the disclosures will include a measure of value of new business. But it will not be the same as that which would be calculated under an MCEV approach.

Sources

• Contract modifications
• New business

Ways of recognition

• Update of the contractual service margin
• Profit or loss (P&L)

Actuarial Modelling

The requirements of the new standard go well beyond any accounting measurement used so far.

At each reporting date, best estimate future cash flows need to be projected and discounted in an appropriate way, using actuarial assumptions and methods. For embedded options, stochastic projections (1000+ scenarios) may be required.

At best, insurers can start from similar measurement frameworks like MCEV or Solvency 2, but will face new challenges from:

• Methodological differences and extra challenges like tracking historical information on the CSM
• Calculation requirements of the Income Statement (requires Analysis of Movement)
• Interface with the accounting process

Operational challenges

Insurance companies that hold on to a Fast Close of their accounting reports will need to design a calculation process that gives flawless results from the first time. The February deadline for publishing accounts will be a key issue if firms want to leverage any tools used in Solvency II reporting (which happens in May).

They will need sufficient processing power to have the current measurement and the analysis of movement for the Income Statement ready in time.

Companies may want to consider a fundamental upgrade of their ICT capacity, for instance by using cloud computing.

The extensive disclosures required under the new Standard will also add to the challenge for companies.

Strategic challenges

The new IFRS standard for insurance contracts has a huge impact on how the performance of an insurer is presented to its stakeholders.

Methodological choices that affect the way that future profits will be determined and released should be well-chosen and properly understood by management.

All stakeholders, including Boards of Management, staff, investors and external communicators will need to be educated on the new standard. The change is likely to result in restatements of the balance sheet when the standard is first applied and this will need to be explained.

Enhanced ALM

The launch of the new insurance contracts IFRS standard will come shortly after, but will not coincide, with the mandatory effective date of IFRS9.

The way the measurement and statement of covering assets interacts with that of insurance contracts will have a huge impact on balance sheet and income statement volatility.

Accounting mismatches are to be minimised or explained carefully to users of the accounting reports.

Companies will need to decide how the ALM target will be set. Is it management of volatility of IFRS earnings or management of the solvency ratio, both of which are based on different value frameworks.

Three Year Transition Period

There will be a transition period of just over three and a half years.

This gives insurers very limited time:

• To build the corresponding processes
• To determine retrospectively the opening measurement value of the insurance business
• To align the income statement measurement of financial assets with that of the new insurance contracts measurement

There are three possible approaches which can be used at the transition date. The Full Retrospective Approach should be used unless impracticable. If this is impracticable, a Modified Retrospective Approach or Fair Value Approach may be used. The Fair Value Approach involves determining the CSM at the transition date as the difference between the fair value of the insurance contract at that date and the fulfilment cashflows measured at that date.

The new IFRS standard for insurance contracts promises to have a transformative effect on insurers' financial reporting.

IFRS calls for a more nuanced and comprehensive approach to risk modelling—an approach that will require not just specialized actuarial expertise, but also unprecedented processing speed to meet strict auditing timeframes.

Milliman has considerable experience with Solvency II and other regulatory regimes, coupled with groundbreaking systems implementation and industrialisation capabilities.