Combination of insurance contracts

An entity might enter into a series of insurance contracts with the same or a related counterparty to achieve an overall economic effect. In order to ensure that the accounting reflects the substance of these contracts, it might be necessary to combine the group or series of contracts and analyse them in their entirety. If, for example, an entity enters into two separate insurance contracts with the same counterparty at the same time with exactly opposite rights and obligations, it does not account for those contracts, because the combined effect is that no rights and obligations exist.

When should insurance and reinsurance contracts with the same or a related party be combined? Question 1 For accounting purposes, should an insurance contract issued to one entity (Insured A) be combined with a reinsurance contract held that is purchased from another entity (Captive Insurer C), where Insured A and Captive Insurer C are in the same consolidated group? Background Insurer B insures specified risks of Insured A through an insurance contract (Contract #1). Insurer B enters into a separate reinsurance contract (Contract #2) with Captive Insurer C, under which Captive Insurer C assumes some (or all) of the same risks specified in Contract #1. Insured A and Captive Insurer C are in the same consolidated group. Answer Accounting by Insurer B It depends. IFRS 17 notes that a series of insurance contracts with a single or related counterparty might be designed to achieve an overall commercial effect. In order to report the substance of such contracts, it might be necessary to combine them. In the above situation, Insurer B should consider whether the two contracts should be combined in order to report the commercial substance. If 100% of the risk assumed under Contract #1 is transferred to Captive Insurer C by Contract #2, this would result in no insurance risk being assumed by Insurer B; accordingly, the definition of an insurance contract would not be met, and thus the contract would not be accounted for as an insurance contract within the scope of IFRS 17. Conversely, if only some of the risk assumed under Contract #1 is transferred to Captive Insurer C by Contract #2, and the net risk that is retained by Insurer B is significant, the net transaction would be treated by Insurer B as an insurance contract under IFRS 17. Regardless of whether the contracts are combined or not, the balance sheet should reflect the terms and conditions of each of the contracts. If a right to set-off exists between amounts owed by Insured A, Insurer B and Captive Insurer C, the balance sheet amounts would be offset. On the other hand, if there is no legally enforceable right to set-off, or Insurer B does not intend to settle on a net basis or simultaneously, it would be necessary to show the gross balances. For example, if there is no net insurance risk in the contract, but claim reimbursements owed by Insurer B to Insured A under legal Contract #1 cannot be offset against any claims recoverable owed to Insurer B by Captive Insurer C under Contract #2, each of the amounts would need to be shown on the balance sheet as separate assets and liabilities. Accounting in the separate financial statements of Insurer A and Captive Insurer C In the separate financial statements of Insured A and Captive Insurer C, each of the two contracts would be accounted for, respectively, as insurance purchased (Insured A) and insurance written (Captive Insurer C) if there was significant insurance risk transferred. Accounting by the group that contains Insurer A and Captive Insurer C In the consolidated accounts of the group, if all of the risk is transferred back to Captive Insurer C, there will be no insurance contract in the consolidated accounts (in much the same way as if a contract were to exist between Insured A and Captive Insurer C). However, if only some of the insurance risk is passed back to Captive Insurer C, with insurance risk being assumed by third party Insurer B, the consolidated group statements would reflect the net insurance purchased. The balance sheet should reflect the terms and conditions of the contracts. If a right to set-off exists between Insured A, Insurer B and Captive Insurer C (that is, a legally enforceable right to set-off and the intent to settle net or simultaneously), the balance sheet amounts would need to be offset; on the other hand, if there is no right to net settlement, it would be necessary to show the gross balances between the group and Insurer B. Question 2 Should reinsurance contracts that pass insurance risk from an insurer (or reinsurer) to a third party reinsurer, and then ultimately pass some or all of that risk back to the original insurer, be combined as one contract? Background Some contracts between insurers and reinsurers pass risk from the insurer (the original insurer or reinsurer) to one or more reinsurers, before ultimately passing back some or all of the risk to the original insurer. This series of arrangements is circular and is often referred to as a ‘spiral’. It exists due to the build-up of retrocession arrangements, given the relatively limited size of the reinsurance market in some territories. Answer It depends. Such contracts might need to be combined if they are entered into with the same or a related counterparty and they achieve, or are designed to achieve, an overall commercial effect. Each entity to the transaction will need to assess whether there is any contractual link between the contracts, whether written or oral or implied by an entity’s business practices, and considering any amendments or side agreements that would result in the transactions being deemed to be ‘with the same or related counterparties’.

When is it necessary to treat a set or series of insurance contracts as a single contract? Question Does IFRS 17 permit or require an entity to combine a set or series of insurance contracts as a single contract in certain situations; and, if so, what are those situations? Background IFRS 17 states that: “A set or series of insurance contracts with the same or related counterparty may achieve, or be designed to achieve, an overall commercial effect. In order to report the substance of such contracts, it may be necessary to treat the set or series of contracts as a whole …” This raises a question as to the circumstances in which it is appropriate to combine separate legal contracts and consider them as one single insurance contract for accounting purposes. This issue was discussed by the IASB Transition Resource Group for IFRS 17 Insurance Contracts (‘TRG’) in May 2018. Answer The May 2018 TRG minutes note that “determining whether it is necessary to treat a set or series of insurance contract as a single contract involves significant judgement and careful consideration of all relevant facts and circumstances”. TRG members discussed factors that might be relevant in the analysis of whether a set or series of contracts achieve, or are designed to achieve, an overall commercial effect and are therefore required to be combined. They noted that no single factor is determinative in applying this assessment but that the following considerations might be relevant: ·        Whether the rights and obligations of the contracts are different when looked at together, compared to when looked at individually – for example, when rights and obligations of one contract negate the rights and obligations of another contract. ·        Whether the entity is unable to measure one contract without considering the other. This might be the case where there is interdependency between the different risks covered in each contract, and the contracts lapse together. The fact that a set or series of insurance contracts with the same counterparty are entered into at the same time, or that a discount applies if a policyholder purchases more than one contract, is not sufficient grounds to conclude that the contracts achieve an overall commercial effect and should be combined; careful consideration of the facts and circumstances is required. TRG members also observed that the principle for combining insurance contracts in IFRS 17 should be consistent with the principle for separating insurance components from a single contract, as discussed at the February 2018 meeting of the TRG.

Separation of insurance contracts

Before an entity accounts for an insurance contract based on the guidance in IFRS 17, it should analyse whether the contract contains one or more components that are required to be separated. IFRS 17 distinguishes between three different components that have to be separated from a host insurance contract if certain criteria are met. These are:

• embedded derivatives;
• investment components; and
• promises to transfer distinct goods or distinct non-insurance services.

An entity applies IFRS 17 to all remaining components of the contract. Separation of other non-insurance components is prohibited.

The lowest unit of account that is used in IFRS 17 is the contract (after separating any required non-insurance components) that includes all insurance components.

Separation of insurance components of a single insurance contract Question Does IFRS 17 permit or require the separation of an insurance contract into smaller insurance subcomponents in certain situations; and, if so, what are those situations? Answer This issue was discussed by the IASB Transition Resource Group for IFRS 17 Insurance Contracts (‘TRG’) in February 2018. The lowest unit of account explicitly mentioned in IFRS 17 is the contract, and there is a presumption that an insurance arrangement with the legal form of a single contract would generally be considered a single unit of account. However, ‘substance over form’ is a relevant principle in applying IFRS 17, just as it is in the application of other IFRSs. There might be certain cases where the legal form of a contract does not reflect the substance, and thus where separation is required for accounting purposes. The Conceptual Framework should be a guiding principle in determining when such separation is appropriate. [February and May 2018 TRG meetings]. The February 2018 TRG minutes note that “overriding the contract unit of account presumption by separating insurance components of a single insurance contract involves significant judgement and careful consideration of all relevant facts and circumstances. It is not an accounting policy choice”. No single factor is determinative in applying the assessment. The TRG cited a few factors that might be relevant to the assessment of whether the legal form as a single contract reflects the substance, including: ·        interdependency between the different risks covered (for example, whether there are shared deductibles and limits); ·        whether the components lapse together; and ·        whether the components can be priced and sold separately. The TRG also noted that: ·        combining different types of products or coverages that have different risks into one legal insurance contract is not, in itself, sufficient to conclude that the legal form of the contract does not reflect the substance of its contractual rights and obligations; ·        the availability of information to separate cash flows for different risks is not, in itself, sufficient to conclude that the contract does not reflect the substance of its contractual rights and obligations; and ·        the fact that a reinsurance contract held provides cover for underlying contracts that are included in different groups is not, in itself, sufficient to conclude that accounting for the reinsurance contract held as a single contract does not reflect the substance. An example of where the presumption that a single legal contract is the lowest unit of account under IFRS 17 might be overridden is a situation where transactions that are typically written as separate contracts have been bundled together as one legal contract, for customer convenience, but where there are no interdependencies between the different components.

Is a surrender option in a motor insurance contract an embedded derivative? Question Does a surrender option for a fixed amount in a motor insurance contract meet the definition of an embedded derivative? Background An entity issues a motor insurance contract with a coverage period of one year and premiums of CU1,000. The policy pays out a maximum of CU3,000 on the insured event, and the amount paid depends on the amount required to repair damage to the car. A policyholder can surrender the contract during the first six months of the coverage period for a fixed amount of CU500. Answer No. The surrender option is not an embedded derivative. IFRS 9 defines a derivative as a financial instrument whose value changes in response to the change in a variable (sometimes called the ‘underlying’). The underlying for a derivative can be either financial or non-financial, provided that (in the case of a non-financial variable) the variable is not specific to a party to the contract. Where a feature (such as a surrender option) has multiple under-lyings and one of them is a financial variable, the definition of an embedded derivative is met, even if the other under-lyings are non-financial and are specific to a party to the contract. The underlying of the surrender option embedded in the motor contract is the insurance risk which, under the definition in IFRS 17, is a non-financial risk and is specific to the policyholder. Therefore, the surrender option embedded in the motor insurance contract does not meet the definition of a derivative, because the underlying is specific to a party to the contract.

Is a surrender option in a unit-linked insurance contract an embedded derivative? Question Does a surrender option for a fixed amount in a unit-linked insurance contract meet the definition of an embedded derivative? Background An entity issues a unit-linked investment contract with an accidental death insurance rider attached. The coverage period of the contract is one year. Initially invested premiums are CU1,000. The policy pays out the account balance on maturity, CU1,000 (fixed amount) on surrender, and 110% of the account balance on accidental death. Premiums are invested in an equity fund. Answer Yes, the CU1,000 fixed surrender option in a unit-linked insurance contract meets the definition of an embedded derivative. However, the CU1,000 surrender option is interdependent with the insurance contract; therefore, it would not be separated and accounted for under IFRS 9, but instead would be measured under IFRS 17. IFRS 9 defines a derivative as a financial instrument whose value changes in response to the change in a variable (sometimes called the ‘underlying’). The underlying for a derivative can be either financial or non-financial, provided that (in the case of a non-financial variable) the variable is not specific to a party to the contract. The underlying affecting the value of the surrender option is the value of the insurance contract that is lost if the contract is surrendered, which will be affected by both financial risks (such as equity prices) and non-financial risks (such as the risk of death of the policyholder). IFRS 9 notes that, if a contract contains more than one embedded derivative, each derivative must be assessed to see whether it warrants separate accounting. Generally, multiple embedded derivatives in a single hybrid contract are treated as a single compound embedded derivative, unless those derivatives relate to different risk exposures and are readily separable and independent of each other. Given that there is financial risk in this contract, there is an embedded derivative to be considered. However, the CU1,000 surrender option is interdependent with the insurance contract; therefore, it would not be separated and accounted for under IFRS 9, but the contract as a whole would be measured under IFRS 17.

Embedded derivatives

An entity applies the guidance in IFRS 9 to determine whether an embedded derivative should be separated.

Under IFRS 9, an embedded derivative is separated and accounted for as a derivative if all of the following conditions are met:

• the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host contract;
• a separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and
• the hybrid contract is not measured at fair value, with changes in fair value recognised in profit or loss.

A derivative embedded in an insurance contract is closely related to the host insurance contract if the embedded derivative and host insurance contract are so interdependent that an entity cannot measure the embedded derivative separately without considering the host contract.

A unit-linking feature embedded within a host insurance contract, being a contractual term that requires payments denominated in units of an internal or external investment fund, is closely related to the host contract if the unit-linked payments are measured at current unit values that represent the fair value of the assets of the fund.

A contract that might result in the payment of an amount linked to a price index does not give rise to a component that is a non-closely related embedded derivative if the payment itself is triggered by an insured event and the transfer of insurance risk is significant.

Investment components

After considering whether a host insurance contract contains an embedded derivative, an entity then separates any investment component that is distinct.

When are entities required to identify investment components? Question Are entities required to identify any non-distinct investment components on initial recognition of an insurance contract? Answer No, entities are only required to identify distinct investment components on initial recognition. Non-distinct investment components are only required to be identified at the time when insurance service income or expense is recognised. IFRS 17 requires an entity to identify and separate distinct investment components on initial recognition of a contract. For non-distinct investment components, IFRS 17 notes that insurance revenue and insurance service expenses should exclude any investment components. Basis for Conclusions to IFRS 17 clarifies that entities are required to identify non-distinct investment components only at the time when revenue and incurred claims are recognised. Therefore, the amount of a non-distinct investment component is not required to be identified on initial recognition. Entities are required to include all cash flows in the estimate of fulfilment cash flows. Entities are not required to identify whether payments are a non-distinct investment component or an insurance service expense before income or expenses are recognised.

IFRS 17 defines investment components as the amounts that the entity has to repay to the policyholder, even if the insured event does not occur.

The investment component is distinct if both of the following criteria are met:

• the investment component and the insurance component are not highly interrelated; and
• a contract with terms equivalent to the investment component is sold, or could be sold, separately in the same market or same jurisdiction; an entity takes into account all reasonably available information when it makes this assessment, but it does not have to undertake an exhaustive search.

An investment component and an insurance component are highly interrelated if the value of one component varies with the value of the other component, and hence the entity is unable to measure each component without considering the other. The components are also highly interrelated if the policyholder is unable to benefit from one component unless the other is also present. This is the case, for example, if the maturity or lapse of one component causes the maturity or lapse of the other component.

Highly interrelated investment component Question In determining whether an insurance contract contains a distinct investment component that is required to be accounted for separately, are the two components highly interrelated if the lapse or maturity of one component causes the lapse or maturity of the second component, or does the expiry of the second component also need to cause the lapse or maturity of the first component (that is, is it a ‘one-way’ or a ‘two-way’ test)? Background IFRS 17 requires distinct investment components to be separated from an insurance contract and accounted for under IFRS 9. An investment component is distinct if it is not highly interrelated, and a contract with equivalent terms is, or could be, sold separately in the same market or jurisdiction. An investment component and an insurance component are highly interrelated if the policyholder is unable to benefit from one component unless the other is also present. Answer This is a ‘one-way’ test. The components will be highly interrelated (and not separated) if the lapse or maturity of only one component causes the lapse or maturity of the second component. There is no further requirement for the second component to cause the expiry of the first component.

A distinct investment component that is separated from the insurance contract is accounted for as a financial instrument within the scope of IFRS 9.

An investment component that is non-distinct and is not separated from an insurance contract for the purpose of measurement should nevertheless be excluded from both insurance revenue and insurance service expenses.

Promises to transfer distinct goods or non-insurance services

After separating non-closely related embedded derivatives and distinct investment components, an entity should separate from the host insurance contract any promise to transfer distinct goods or non-insurance services to a policyholder.

A good or non-insurance service is distinct if the policyholder can benefit from the good or service either on its own or together with other resources that are readily available to the policyholder. A resource is readily available if it is either sold separately or the policyholder already owns it.

A good or non-insurance service is not distinct if the cash flows and risks associated with that good or service are highly interrelated with those of the insurance components and the entity provides a significant service in integrating the good or service with the insurance components.

Activities that an entity has to perform to fulfil the insurance contract, such as administrative tasks to set up the contract, are not separated, because these tasks do not transfer a service to the policyholder.

What types of activity would be considered to represent distinct service components? The criteria in IFRS 17, to assess whether a promise to transfer goods or noninsurance services is distinct, are similar to the criteria in IFRS 15. Under both standards, an entity should analyse whether the customer is able to benefit from the good or service, either on its own or together with resources that are readily available, and whether the transfer of the good or service is interrelated with other components of the contract. Under certain circumstances, the additional guidance provided in IFRS 15 might therefore be helpful in interpreting the term ‘distinct’ in IFRS 17. In general, processing the claims received is part of the activities that the insurer must undertake to fulfil the contract, and it is not a distinct service that should be separated. However, there are exceptions, in particular if the insurance company provides the service to an entity that self-insures a part of its risks.

Once the entity has concluded that a promise to transfer goods or non-insurance services is accounted for separately, it should apply IFRS 15 to attribute the cash inflows between the insurance component and any promises to provide distinct goods or non-insurance services. Cash outflows that directly relate to each component should be attributed to that component, with any remaining cash outflows being attributed on a systematic and rational basis.