Application of IFRS 17 to entities other than regulated insurers

Reference to standard: IFRS 17 para 3

Question

Does IFRS 17 apply to entities other than regulated insurers?

Answer

IFRS 17 is relevant not only for insurance companies. All entities that issue contracts that meet the definition of insurance contracts in IFRS 17 and that are not within one of the scope exceptions are within the scope of the standard.

So, for example, manufacturers, dealers or retailers sometimes retain certain risks related to the product sold that go beyond the types of warranty or residual value guarantee that are explicitly outside the scope of the standard. Telecommunication companies might, for example, provide protection against theft, loss or damage for mobile devices that they have sold. These kinds of contracts are likely to meet the definition of an insurance contract and are accounted for applying IFRS 17, unless they are specifically excluded from the scope of IFRS 17 and are accounted for applying other IFRS standards (for example, a fixed-fee service contract can be accounted for using either IFRS 17 or IFRS 15).

Contracts that are insurance contracts

Reference to standard: IFRS 17 para B26

Examples of insurance contracts (if the transfer of insurance risk is significant) are as follows:

·        Insurance against theft or damage to property.

·        Insurance against product liability, professional liability, civil liability or legal expenses.

·        Life insurance and pre-paid funeral plans.

·        Life-contingent annuities and pensions.

·        Disability and medical cover.

·        Travel insurance.

·        Surety bonds, or performance bonds (that is, contracts that compensate for failure to perform a contractual obligation).

·        Title insurance.

·        Catastrophe bonds that provide for reduced payment if a specified adverse event that creates significant insurance risk adversely affects the issuer.

·        Insurance swaps that relate to climatic, geological or physical variables that are specific to a party to the contract.

Contracts that are not insurance contracts

Reference to standard: IFRS 17 para B27, B28

Examples of contracts that are not insurance contracts are as follows:

·        Investment contracts that have the legal form of an insurance contract but do not transfer significant insurance risk.

·        Retrospectively rated contracts that pass all significant insurance risk back to the policyholder (for example, through enforceable mechanisms that adjust future premiums as a direct result of incurred losses), such as some financial reinsurance or group contracts.

·        Derivatives that expose one party to financial risk (such as changes in interest rate, commodity prices, foreign exchange rates and indexes) rather than insurance risk.

·        Contracts that require a payment related to an uncertain future event. However, the contract does not require the event to adversely affect the policyholder (for example, a gambling contract).

·        Credit-related guarantees that trigger payments, even if the holder has not incurred a credit loss.

·        Catastrophe bonds that provide for reduced payment of principal, interest or both, based on climatic or geological variables not specific to a party to the contract.

An entity should apply other applicable standards, such as IFRS 9 or IFRS 15, to these contracts.

Equity release mortgage with a ‘no negative equity’ guarantee

Reference to standard: IFRS 17 App A

Question

How should an entity account for an equity release or ‘reverse’ mortgage with a ‘no negative equity’ guarantee?

Background

An entity issues an equity release or ‘reverse’ mortgage with a ‘no negative equity’ guarantee. The contractual terms secure the mortgage against the borrower’s property. Interest is accrued. Principal and accrued interest are payable when the borrower dies or moves into long-term care. The property is then sold and the proceeds used to repay the mortgage balance (including any accrued interest). The entity is not entitled to any excess of the sales proceeds over the amount due, but it bears any shortfall where the sales proceeds are not sufficient to repay the principal and accrued interest. Assume that the entity holds the equity release mortgage within a ‘hold to collect’ business model, and that the contract contains no other features that could cause it to fail the ‘SPPI’ test in IFRS 9.

Answer

The contract exposes the entity to the risk of changes in fair value of the borrower’s property (a non-financial asset). That is not a financial risk, because the fair value of the property reflects not only changes in market prices for properties in general (a financial variable) but also the physical condition of the specific asset (a non-financial variable). The contract therefore transfers insurance risk, as well as financial risk, from the borrower to the entity. Under IFRS 17, a contract is treated as an insurance contract only if it transfers significant insurance risk, which arises if an insured event could cause an insurer to pay significant additional benefits in at least one scenario with commercial substance. If that is the case and the entity could pay significant additional benefits to the policyholder/mortgagee in at least one scenario with commercial substance, the instrument is an insurance contract within the scope of IFRS 17.

If the contract does not transfer significant insurance risk, it is within the scope of IFRS 9. Since the entity holds the equity release mortgage within a ‘hold to collect’ business model, the classification and measurement of the contract under IFRS 9 is determined based on the contractual cash flow characteristics of the financial asset (the ‘SPPI’ test) in accordance with IFRS 9. In performing the SPPI test, the entity needs to consider whether the possible effect of the ‘no negative equity’ guarantee is more than ‘de minimis’ and is genuine. In doing so, important considerations are that:

·        The ‘significant additional benefits’ threshold in IFRS 17 is not the same as the ‘de minimis’ threshold in IFRS 9. ‘De minimis’ is a stricter threshold with regard to cash flow variability, and it is only met when the possible effects on cash flows are clearly trivial or negligible.

·        In assessing whether the cash flows under the guarantee could arise only on the occurrence of an extremely rare, highly abnormal or very unlikely event, so are not genuine, it should be questioned why the clause was included in the contract if it has no apparent commercial purpose. The remainder of this FAQ assumes that the clause is genuine.

As a result, the equity release or ‘reverse’ mortgage will be measured in one of three ways, depending on the extent of the possible cash flow variability arising from the ‘no negative equity’ guarantee:

·        as an insurance contract under IFRS 17, where significant additional benefits accrue to the borrower (in the form of forgiveness of a shortfall that would otherwise be due) in at least one scenario with commercial substance;

·        as a financial instrument under IFRS 9 at fair value through profit or loss, where the additional benefits will not be significant in any scenario with commercial substance but could be more than ‘de minimis’ (that is, cash flows received are not SPPI, because losses are borne by the lender if proceeds on sale of the property are insufficient to repay outstanding principal and interest); or

·        as a financial instrument under IFRS 9 at amortised cost, where the additional benefits could never be more than ‘de minimis’. Each individual contract should be analysed based on its specific facts and circumstances.

Classification of a reinsurance contract which covers the movement in value of a death benefit as a result of the change in an index

Reference to standard: IFRS 17 paras B9, B10

Question

Does a reinsurance contract which covers the movement in value of a death benefit as a result of the change in an index transfer significant insurance risk, such that it is within the scope of IFRS 17?

Background

Insurer A sells life coverage products, where the insured value is indexed by inflation (measured as the change in CPI) for the duration of the product. The insured value can grow in excess of CPI, up to a maximum of 25% per annum, linked to the return of a chosen overseas index or basket of indices or exchange rates. The policies have no surrender values; amounts are paid under a policy on death or disability only. The policy issued meets the definition of an insurance contract in IFRS 17.

The original insurance contract value consists of the following components:

Contract value = original sum insured + CPI + (index movement if > 0 to a max of 25% pa).

Insurer A has entered into a reinsurance contract which hedges the index return portion of the policy in the event of death of the policyholder. The reinsurance contract is not for the full value, but only for the risk that the index option will be ‘in the money’. The reinsurance contract value is as follows:

Contract value = index movement if > 0 to a max of 25% pa. Both the insurance and the reinsurance contracts pay on death or disability only.

Is the reinsurance contract within the scope of IFRS 17?

Answer

Yes. The reinsurance contract transfers insurance risk, as defined in Appendix A to IFRS 17, and that insurance risk is significant. The reinsurance contract will only pay in the case of an insured event (death or disability of the policyholder). The payment is not based solely on changes in one or more financial risk, but rather on the combination of an insurance risk and financial risk. Paragraph B9 of IFRS 17 states that some contracts expose the issuer to financial risk in addition to significant insurance risk, and that such contracts are insurance contracts.

Under some contracts, an insured event triggers the payment of an amount linked to a price index. Such contracts are insurance contracts, provided that the payment contingent on the insured event could be significant. The payment, being dependent on the death or disability of the policyholder, transfers insurance risk. The resulting transfer of insurance risk is significant, because it is possible that index returns in excess of CPI will form a significant portion of the total contract value. Therefore, the reinsurance contract meets the definition of an insurance contract.

Is a contract classified as an insurance contract if it reinsures lapse risk and expense risk?

Reference to standard: IFRS 17 para B9

Question

Is a contract classified as an insurance contract if it reinsures lapse risk and expense risk on an underlying portfolio of investment contracts?

Background

Insurer Y writes unit-linked investment contracts. Investment contracts can take the form of unit-linked investment contracts, where the benefits payable to the contract holder are contractually linked to the fair value of a pool of underlying assets (‘the linked fund’). The only risks that insurer Y has under these contracts are expense risk (that is, the risk that it costs more to administer these contracts than the charges made to the policyholder) and lapse risk on a portfolio of unit-linked investment contracts (that is, the risk that the policyholder surrenders the policy sooner than anticipated). Insurer Y reinsures the expense and lapse risk to insurer Z, such that any additional costs that insurer Y bears on the portfolio, from adverse expense and lapse experience, is borne by insurer Z.

For the insurer, are the unit-linked contracts and the reinsurance contract within the scope of IFRS 17?

Answer

No. The unit-linked contracts written by insurer Y are not insurance contracts, because neither lapse risk nor expense risk adversely affects the policyholder. The unit-linked contracts will be classified as investment contracts and accounted for under IFRS 9.

The contract between insurer Y and insurer Z is an insurance contract under IFRS 17. Insurer Y is the policyholder of the contract and will be adversely affected by both lapse and expense risk, while the contract exposes insurer Z to this insurance risk.

A reinsurance contract is defined in Appendix A to IFRS 17 as an insurance contract issued by one entity (the reinsurer) to compensate another entity for claims arising from one or more insurance contracts issued by that other entity. Therefore, the contract between insurer Y and insurer Z is not a ‘reinsurance’ contract, as defined in IFRS 17, because the underlying unit- linked contracts are investment contracts accounted for under IFRS 9, rather than insurance contracts. Therefore, insurer Y does not apply IFRS 17 to its contract with insurer Z.

Do terms in a contract that waive premiums in specified circumstances create insurance risk?

Reference to standard: IFRS 17 para B11

Question

Do such terms as ‘premium waiver’ in a contract, that allow a policyholder to avoid paying premiums, represent a pre-existing risk of the policyholder transferred to the entity (and hence insurance risk) or a new risk created by the contract (and hence not insurance risk)?

Background

Some contracts include terms that allow a policyholder to avoid paying premiums in specified circumstances (for example, if the policyholder has been disabled for six consecutive months). In this situation, the policyholder continues to receive the benefits originally promised under the contract. This contractual term can sometimes be known as a ‘premium waiver’.

Answer

At the September 2018 meeting of the IASB Transition Resource Group for IFRS 17 Insurance Contracts (‘TRG’), it was concluded that there is insurance risk if the event that gives rise to the premium waiver (for example, becoming disabled) adversely affects the policyholder and is a risk transferred to the issuer of the contract (that is, the risk that waives the premiums existed prior to the contract). Therefore, the risk that the issuer of the contract is obligated to continue to provide the same benefits (for example, other insurance coverage or investment services) to the policyholder, without receiving any consideration, is insurance risk.

The existence of a premium waiver in a contract that otherwise would be an investment contract could result in a contract being classified as an insurance contract in its entirety (unless the investment component separation criteria are met) if the premium waiver constitutes significant insurance risk.

The existence of a premium waiver in insurance contracts (for example, a term life insurance policy with a premium waiver on disability) is likely to provide different patterns of coverage, and it could also impact the coverage period to the extent that the coverage period for the waiver differs from that of the base insurance contract.

Can an insurance contract exist if the probability of the insured event is low?

Reference to standard: IFRS 17 para B18

Yes. An entity has a contract which requires an insurer to reimburse it for the value of a property that it owns in the event of the property being destroyed by a hurricane. The likelihood of a hurricane destroying a building is low (although the scenario has commercial substance), but the payment by the insurer would be substantial. In all other scenarios, a similar payment would not be made. The contract is therefore an insurance contract, because the insurance risk is significant.

Classification of ‘whole of life unitised with-profit’ contracts

Reference to standard: IFRS 17 para B20

Question

Does a ‘whole of life unitised with-profit’ discretionary participating contract with a market value adjustment (MVA) meet the definition of an insurance contract?

Background

Insurer A issues a discretionary participating contract with no maturity date (‘whole of life’ policy) and with unitised discretionary benefits (‘unitised with-profit’). Insurer A determines the death benefits under the policy as a unit price based on the unitised value of a specified investment fund that it holds. The insurer applies its discretion to determine a minimum death unit price, to smooth the fluctuations in the fair value of the underlying assets. Insurer A cannot reduce the minimum death unit price determined in previous periods. In the event of the policyholder’s death, the benefits are based on this minimum death unit price, even if the fair value of the underlying assets is particularly low at that time.

If the holder elects to surrender the contract, insurer A can apply an MVA to pay a benefit equal to the fair value of the underlying assets. However, if the fair value of the underlying assets at the date of surrender or death is higher than the minimum death benefit, insurer A pays the higher amount. In this scenario, the benefits payable on death and on surrender are identical.

Answer

It depends. If the expected volatility of the assets held in the specified investment fund creates scenarios where the adjusted value of the death benefits, determined on a present value basis, could be significantly higher than the fair value of the underlying assets, the contract is an insurance contract, as defined in Appendix A to IFRS 17.

Contracts that offer, on death, the greater of unit value and return of premiums

Reference to standard: IFRS 17 para B20

Question

Are contracts that offer, on death, the greater of unit value and accumulated premiums classified as insurance contracts under IFRS 17?

Background

An insurer issued a contract that provides a death benefit, being the greater of unit account value or payment of accumulated premiums paid to date on the contract if the policyholder dies. The policyholder has the right to surrender the contract, and he will receive the unit value if he exercises that option.

This feature is presented in the graphic below:

Answer

Yes, provided that there is a scenario with commercial substance in which the present value of death benefits (based on the accumulated premiums) is significantly higher than the unit value benefits. The graphic above shows that, during market downturns, there is the possibility that the insurer has mortality risk, in the event that the cumulative premiums are in excess of the unit account value at the time of death. In this case, there is an additional benefit, which is the difference between the unit value and the accumulated premiums.

The insurer must determine at inception whether the insurance risk that the contract transfers is significant – that is, whether the underlying assets are sufficiently volatile to create a scenario with commercial substance in which the present value of death benefits (based on the accumulated premiums) is significantly higher than the unit value benefits.

Classification of a last survivor deferred annuity where the annuitants are the immediate family

Reference to standard: IFRS 17 para B18

Question

How should an insurer classify a deferred annuity contract where the beneficiaries entitled to receive the annuity payments are the policyholder and, on his death, any surviving members of his immediate family?

Background

Insurer X issues deferred annuity contracts. In accordance with local pension tax laws, a policyholder has to select one of the following three options at the inception of the contract:

Option 1: The annuity will be payable for as long as the policyholder survives.

Option 2: The annuity will be payable for as long as the policyholder and any other surviving members of his immediate family (that is, the policyholder, the policyholder’s spouse, and the policyholder’s children up to a certain age) survive. This option requires the insurer to pay the annuity also on death of the policyholder prior to the annuity vesting date if there are surviving members of his immediate family.

Option 3: The annuity will be payable for as long as the policyholder and any other surviving members of his immediate family (that is, the policyholder, the policyholder’s spouse, and the policyholder’s children up to a certain age) survive, up to a maximum fixed period of time selected by the policyholder at the inception of the contract, subject to a minimum period of five years.

Annuity rates are guaranteed at inception. However, for option 3, no mortality risk is considered by the insurer in determining the premium that the policyholder pays for the annuity.

Answer

Contracts with either option 1 or 2 qualify as insurance contracts. In both cases, the annuity is life-contingent (either on the life of the policyholder in option 1, or on the life of the policyholder or his surviving family members in option 2), and it has been issued at rates guaranteed at inception. Such contracts normally transfer significant insurance risk in accordance with IFRS 17.

Under option 3, insurer X should assess whether there are scenarios with commercial substance that would transfer significant insurance risk. The insured event is survival until the date when the annuity is payable. One scenario is that at least one of the family members remains alive throughout the term of the annuity. The annuity payments represent the benefits payable for the insured event occurring – that is, the beneficiaries survive throughout the annuity term (scenario A).

This should be compared with the benefits payable under another scenario: where all of the family members die before the end of the contract (scenario B). Under scenario A, the insurer has to make greater annuity payments than under scenario B, and the difference (determined, in both scenarios, on a present value basis) is likely to be significant.

Insurer X needs to assess whether or not both of these scenarios have commercial substance. This means that insurer X determines whether they have a discernible effect on the economics of the contract. Although mortality risk was not taken into account when pricing the contract under option 3, in the event of scenario B occurring, there will be a discernible effect on the profits of the insurer. For example, if the whole family were to die in the same incident, such as a motor car accident, before the end of the annuity term, there would be a discernible impact on the insurer’s profitability. Therefore, scenario B has commercial substance, and the contract in option 3 is an insurance contract.

Is there a transfer of significant insurance risk if only insignificant payments arise when the insured event occurs?

Reference to standard: IFRS 17 para B21(c)

No. For example, if a contract requires the issuer to pay CU1 million to the holder if an asset suffers physical damage causing an insignificant economic loss of CU1 to the holder, the holder transfers to the insurer only the insignificant loss of losing CU1. In addition, the requirement in the contract that the issuer also needs to pay CU999,999 if the physical damage occurs creates non-insurance risk. Because the issuer does not accept significant insurance risk from the holder, this contract is not an insurance contract.

Are saving contracts, where the holder enters into periodic lotteries that award cash prizes, insurance contracts?

Reference to standard: IFRS 17 App A

Question

Is a saving plan, with rights to receive cash awards based on lottery-type draws, an insurance contract under IFRS 17?

Background

An entity issues a contract whereby the customer pays monthly deposits of CU100 under a 60-month saving plan, with a guaranteed annual interest of approximately 6% (equivalent to market rates applicable to saving accounts or other inflation index). Interest is only accrued for those monthly deposits which are not withdrawn after the first 12 months of the plan. These plans are sometimes referred to as ‘capitalisation plans’. Customers are entered, during the term of the plan, into monthly lotteries that award a cash prize equivalent to 1,000 times the amount of the last deposit made (that is, cash prize equals CU100,000). Each customer receives a certificate with a numerical identification that might coincide with the winning numbers from the National Lottery. Every month, there will be one winner amongst all participants in the plan. The deposits are redeemable in full, plus interest, only after one year. If the customer redeems the monthly deposits before one year, it will be subject to a surrender penalty. Surrender penalties are applied during the whole term of the contract, and they vary from 90% at inception of the contract to 0% after the 60 months, in order to encourage customers to keep their funds with the entity for a longer period of time. At inception of the contract, all customers nominate a beneficiary that will receive the prize or the accumulated surrender value of the deposits in the event of the customer’s death.

Answer

No, this is not an insurance contract, as defined in Appendix A to IFRS 17. Although it is clear that there is a substantial benefit to be paid to a customer who wins the monthly lottery, the fact that the customer has the winning lottery numbers does not qualify as an insured event, because the event does not affect the customer adversely. This is a gambling contract.

Can an insurance contract exist if the contract is based on a climatic variable that is not specific to a party to the contract?

Reference to standard: IFRS 4 para B27(g)

No. A company has a contract under which it will receive payments if temperatures exceed 45 degrees centigrade. Contracts that require a payment based on climatic variables (sometimes described as ‘weather derivatives’), or on other geological or other physical variables, are not insurance contracts. Such contracts do not require an adverse effect on the policyholder as a precondition of payment. The risk transferred arises from a variable that is a non-financial variable not specific to either party to the contract. This is not an insurance contract, even if the policyholder uses the contract to mitigate an underlying risk exposure. A weather derivative that is triggered by its ‘underlying’ pays, even if the holder has not suffered any damage from the weather.

Classification of purchased existing life insurance contracts

Reference to standard: IFRS 17 para B11 Reference to standing text: 50A.16 Industry: Insurance

Question

Where a ‘buyer’ effectively purchases an existing life insurance contract from the original policyholder, by paying cash and taking over the premium payment obligation on the life insurance policy, and receives the pay-out on the death of the insured, does this transaction meet the definition of an insurance contract?

Background

An individual (the original policyholder) might ‘sell’ his life insurance policy to a third party for an upfront lump-sum cash pay-out that is typically higher than the policy’s cash surrender value but less than the benefit payable on death. This is achieved by the individual entering into a new contract with the buyer (often an ‘investment fund’) who pays cash upfront and assumes the responsibility to pay the premiums on the original contract from the original policyholder. In return, the original policyholder cedes the policy benefits to the buyer. The buyer then takes over the premium payment obligation and, in return, receives the pay-out on the death of the insured. The risk for the investment fund is that the original policyholder lives for longer than anticipated and that the additional premium payments significantly erode the expected return or even cause a loss of the principal amounts paid.

Answer

The investment fund can treat the instrument as a financial instrument under IFRS 9. This treatment is followed if the contract is not considered to be an insurance contract as a result of the original policyholder having no longevity risk exposure before it entered into the new contract with the investment fund; this is because the policyholder has the right to cancel the existing life insurance contract at any point in time. Under this view, the asset will be accounted for applying the classification and measurement requirements of IFRS 9. Since the contract does not give rise to cash flows that are solely payments of principal and interest, it will be measured at fair value through profit or loss.

Alternatively, the investment fund can treat the instrument as an insurance contract. This is based on the view that, after its initial purchase of the life insurance contract, the policyholder had longevity risk (that is, the risk that the policyholder would live longer than anticipated and therefore the premiums paid would be greater than the benefits received). By selling the insurance contract to the investment fund, the policyholder has now passed the longevity risk on to the investment fund. As such, the investment fund is the insurer. Under this view, the investment fund would apply IFRS 17 to the contract.

Captive insurance subsidiaries

Reference to standard: IFRS 17 para B27(c)

Question

If a non-insurance group self-insures through a captive insurance subsidiary, is this arrangement within the scope of IFRS 17?

Answer

A non-insurance group can self-insure, using a captive insurance subsidiary to give insurance cover to all of the members of the group for risks to which those group members are exposed through their business activities. This allows the captive insurer to pool the risks of the members of the group. The pooled risk might mean that the captive can insure (or reinsure) the pooled risks more cheaply with an insurer (or reinsurer) external to the group. If the captive insurance subsidiary presents separate financial statements and assumes significant insurance risks under the contracts with the other members of the group, it treats those as insurance contracts under IFRS 17. The transactions between the captive and the other members of the group are eliminated on consolidation, as are all other intra-group transactions. If the captive holds a reinsurance contract with a third-party reinsurer, the group is the policyholder in that relationship, and so IFRS 17 does not apply to this contract in the group’s consolidated financial statements.

Classification of contracts where the holder has not received any insurance guarantees other than the option to buy a life-contingent annuity at a future date

Reference to standard: IFRS 17 para B24

Question

When does a contract, where the holder has received no insurance guarantees other than the option to buy a life-contingent annuity at a future date, transfer insurance risk?

Background

An insurer regularly issues contracts which do not provide the holder with any insurance guarantee other than an option exercisable at a future date to convert the capital created by his premium payments (and associated interest) into a life-contingent annuity. The insurer operates in a number of different legal jurisdictions. In some jurisdictions, annuity rates are established at inception by law or regulation and are guaranteed at maturity. However, in other jurisdictions, the insurer issues contracts stipulating that the annuity rates will be those in force at the date when the option are exercised.

Answer

It depends. According to paragraph B24 of IFRS 17, if the contract specifies the annuity rates (or a basis other than market rates for setting the annuity rates), the contract transfers insurance risk to the issuer, because the issuer is exposed to the risk that the annuity rates will be unfavourable to the issuer when the policyholder exercises the option. In that case, the cash flows that would occur when the option is exercised are within the boundary of the contract. If the life-contingent payment is significant, in scenarios with commercial substance, the contract meets the definition of an insurance contract.

However, if the contract stipulates that the annuity rate will be that in force at the date when the option is exercised, there is no transfer of insurance risk, and the contract will not meet the definition of an insurance contract until the option to receive the annuity is exercised. According to paragraph B24 of IFRS 17, such a contract transfers insurance risk to the insurer only after the option is exercised, because the insurer remains free to price the annuity on a basis that reflects the insurance risk that will be transferred to the entity at that time. Consequently, the cash flows that would occur on the exercise of the option fall outside the boundary of the contract, and before exercise there are no insurance cash flows within the boundary of the contract.

Classification of deferred annuity contract with option to convert at constrained, but not guaranteed, rates

Reference to standard: IFRS 17 para B24

Question

Does a deferred annuity contract, that imposes certain constraints on the issuer’s ability to set annuity rates at conversion but does not specify a single guaranteed interest rate, meet the definition of an insurance contract at inception?

Background

Insurer A issues investment savings contracts that, on maturity, contain an option for the policyholder to use the proceeds of the investment to buy a life contingent annuity.

Scenario 1: The contract imposes constraints on the mortality rates that the issuer can use to determine the annuity rate at the time when the option is exercised and the annuity vests. The contract requires the issuer to use mortality rates published at inception of the deferred annuity contract to determine annuity payments. However, there is no constraint on the interest rates that the issuer will use to determine the annuity payments.

Scenario 2: The contract provides for a specified fixed interest rate to be used to determine annuity payments at the time when the option is exercised and the annuity vests. The contract does not provide for specific mortality rates, but it does set certain constraints on the mortality rates that the issuer can use to determine the annuity rate – that is, the contract requires the issuer to determine annuity rates using mortality rates published by the local insurance regulator at the annuity vesting date.

Answer

Scenario 1

No. The annuity rate is determined by a combination of the expected mortality rate and the interest rate. Unless both of these rates are constrained at inception, there is no transfer of insurance risk prior to the exercise of the option to convert the investment product into a life-contingent annuity, and so the contract does not constitute an insurance contract. The transfer of significant insurance risk occurs from inception only where the issuer has no ability to vary the terms of the annuity rate to achieve a market equivalent annuity rate. Where the constraint is partial, the rates are effectively unconstrained, since the insurer can adjust the unconstrained factor (that is, the interest rate in this example) to achieve a market rate.

Scenario 2

It depends. The transfer of significant insurance risk occurs from inception only where the issuer has no ability to vary the terms of the annuity rate to achieve a market-equivalent annuity rate. IFRS 17 notes that:

“if the contract specifies the annuity rates (or a basis other than market rates for setting the annuity rates), the contract transfers insurance risk to the issuer because the issuer is exposed to the risk that the annuity rates will be unfavourable to the issuer when the policyholder exercises the option.”

The contract specifies mortality rates published by the regulator at the annuity vesting date. Although these rates are not absolute rates, the basis for the rates is known and fixed at inception. This means that the mortality rates are not within the control of the issuer, such that the issuer does not have the ability to vary the terms to achieve a market-equivalent rate. The ultimate decision, as to whether the annuitisation terms result in the contract meeting the definition of an insurance contract, is whether the combination of the specified interest rate and the published regulatory mortality rates together could result in significant insurance risk to the issuer.

Investment contracts with discretionary participation features in consolidated financial statements and individual financial statements of a subsidiary

Reference to standard: IFRS 17 para B3(c)

Question

Can contracts be accounted for differently in consolidated and individual financial statements?

Background

Entity S is a subsidiary of entity P, and it has issued investment contracts with discretionary participation features but no insurance contracts. Entity P issues insurance contracts.

Answer

Yes. The investment contracts are accounted for as liabilities or as compound instruments within the scope of IFRS 9/IAS 32 in the separate financial statements of entity S; but they are accounted for as investment contracts with discretionary participation features within the scope of IFRS 17 in the consolidated financial statements of the group.

Investment contracts where crediting rate is determined by reference to a benchmark interest rate plus a discretionary spread

Reference to standard: IFRS 17 App A

Question

Where the issuer’s contractual discretion to set the crediting rate at each quarterly declaration date is constrained by a requirement to follow a particular benchmark plus a discretionary positive spread, is the contract an investment contract with discretionary participation features?

Background

The insurer declares its annual crediting rate to holders of its investment contracts at the beginning of the annual period. The insurer is contractually required to base the rate on the fed funds rate at the declaration date, and it has the discretion to add a positive spread. The insurer’s past practice is to base the positive spread on the past and anticipated performance of the debt securities that it holds.

Answer

No, this does not create an investment contract with discretionary participation features, as defined in Appendix A to IFRS 17. This is because the benefits attributable to the holders are not contractually based on the performance of the underlying assets. This is the case even if, in practice, the issuer regularly monitors the return on its assets.

Warranty contracts: eligibility for scope exception – paragraphs 7(a) or 8 of IFRS 17

Reference to standard: IFRS 17 paras 7(a), 8

A consumer electronics company provides its customers, at the time of the sale of its electronics products, with a 3- year free of charge warranty to cover repairs due to manufacturing defects. In addition, for a fixed price, the customer can purchase a further 2 year extended warranty repair cover, which is offered through a warranty subsidiary of the manufacturing company.

Question 1:

Are either of these two warranty products insurance products that are in scope of IFRS 17 at the consolidated group level?

Answer

No. From a group perspective, the electronic products, the 3-year warranty, and the 2-year extended warranty are provided by the same reporting entity. There will be insurance risk in the contract, as either the number of services to be performed or the nature of those services, or both, is uncertain. Both the warranty and the extended warranty contracts provide protection to the customer against an ‘uncertain future event’ and assuming that risk is significant, would meet the insurance contract definition. However, as both types of warranty are available at the time of the sale, they will meet the scope exclusion in IFRS 17 which notes that an entity does not apply IFRS 17 to “warranties provided by a manufacturer, dealer or retailer in connection with the sale of its goods or services to a customer” and references IFRS 15, ‘Revenue from contracts with customers’, for further guidance.

Question 2:

Would the answer change if the extended warranty contract is provided at a later date and the terms of the original sale did not provide for the future purchase of the warranty at a fixed price?

Answer

If the extended warranty is provided at a later stage and not in conjunction with the sale (that is, the terms of the original sale did not provide for the future purchase of the warranty at a fixed price), it will not meet the exemption in IFRS 17 as it is not ‘in connection with the sale’. However, if the product meets the paragraph 8 fixed fee service criteria (no risk assessment in the price determination, the provision of service rather than cash payments to the customer, and frequency risk rather than severity risk), it is eligible for voluntary exemption from IFRS 17.

Question 3:

Would the answer change at the level of the subsidiary providing the extended warranty services?

Answer

For the separate financial statements of the subsidiary that provides the extended warranty cover, the scope exclusion in paragraph 7(a) would not apply, as the repairs and maintenance are provided by a party other than the manufacturer, retailer or dealer. The paragraph 8 fixed fee service considerations would apply at the subsidiary level, as discussed above.

Can the scope of financial guarantees be reassessed on transition to IFRS 17?

Reference to standard: IFRS 17 para 7 (e) Reference to standing text: 50A.27 Industry: Insurance

Background

IFRS 17 states that financial guarantee contracts are outside the scope of the standard, unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to these insurance contracts. If so, entities are given the irrevocable choice, on a contract-by-contract basis, to apply either IFRS 17 or IAS 32, IFRS 7 and IFRS 9.

Question 1

Can an entity, on transition to IFRS 17, reassess the scope of which standard it chooses to apply for financial guarantee contracts previously accounted for under IFRS 4?

Answer

Yes. Although the scope exemptions in IFRS 17 and IFRS 4 are similar, on transition to IFRS 17 an entity applies the requirements in IFRS 17 for the first time and, consequently, it can make the policy election for the first time. Therefore, at the transition date to IFRS 17, an entity currently applying IFRS 4 to existing financial guarantee contracts can choose to apply IFRS 17, or it can instead choose to apply IFRS 9 to such contracts. Either approach would result in a change in accounting policy and would require application of IAS 8 for such changes (or use of the transitional reliefs in IFRS 17, if that is selected).

Question 2

Is an entity that currently accounts for financial guarantee contracts as financial instruments under IAS 39 or IFRS 9 allowed to account for them under IFRS 17 when IFRS 17 is adopted?

Answer

No. For existing financial guarantee contracts currently accounted for under IAS 39 or IFRS 9, the criterion “unless the issuer has previously asserted explicitly that it regards such contracts as insurance contracts and has used accounting applicable to insurance contracts” will not be met.

Examples of ‘fixed-fee service contracts’

Reference to standard: IFRS 17 para 8

Question

What are some examples of a fixed-fee maintenance contract referred to in paragraph 8 of IFRS 17?

Answer

Examples are maintenance contracts under which the service provider is obliged to repair specified equipment after a malfunction, or car breakdown services in which the provider is obliged to provide roadside assistance or tow the car to a nearby garage. Because the level of service and thereby the obligation of the service provider depends on an uncertain future event, these kinds of contract might meet the definition of an insurance contract.

Fixed-fee property maintenance contract

Reference to standard: IFRS 17 para 8

Question

When is a ‘fixed-fee property maintenance contract’ an insurance contract that is within the scope of IFRS 17?

Answer

Entity P owns a portfolio of properties. It outsources its property maintenance and repair on all of these properties to entity S, a property management company, for a five-year period for a fixed fee. This fee covers both property management and the cost of repair work. All repairs and maintenance required to maintain the properties to an agreed standard, based on the condition on inception of the contract, are now the responsibility of entity S. In entering into this contract, entity S made an assessment of the risks and likely repairs that would be required in respect of the specific portfolio of properties owned by entity P. This included normal wear and tear and certain other conditions (such as dry rot and damp, should they be discovered in the course of any remedial work). The price was fixed at the outset. Repairs required as a result of external events, such as fire or storm damage, continue to be covered by entity P’s property insurance arrangements with a regulated insurance company.

Where either the number of services to be performed over a period or the nature of those services is not pre-determined, there can be significant insurance risk. There is uncertainty in the situation above in the following areas:

·        whether any particular repair will be required;

·        when any particular repair will be required; and

·        how much any particular repair will cost.

There is a specified uncertain event, because it is uncertain when or if any particular repair will be required and how much it might cost. The significance of the insurance risk for entity S is assessed, on a contract-by-contract basis, under IFRS 17. Insurance risk could be significant, even though there might be a minimal probability of material losses for entity S arising from all of its property management contracts, because a significant loss could arise on any one contract, such as the contract with entity P. If the insurance risk is significant, IFRS 17 will apply. Since entity S priced the contract based on an assessment of the risk associated with entity P’s properties, this contract cannot be eligible to be accounted for under IFRS 15 in accordance with the ‘fixed-fee service contract’ scope exemption.