Most IFRS accounting standards recognize and measure financials at the individual contract level, for example, IFRS 15 revenue from contracts and customers, and IFRS 9 financial instruments. However, insurance companies underwrite large numbers of similar contracts to pool risk. For this reason, the IASB has introduced IFRS 17 guidelines for contract aggregation for purposes of the calculation and adjustment of the Contractual Service Margin (CSM). These guidelines allow the use of a unit of account that is higher than the individual insurance contract.
The unit of account is determined by the level of aggregation, which determines the level of granularity at which onerous insurance contracts are identified and how the insurance revenue is recognized in financial statements. Therefore, the level of aggregation affects how the profitability of the business is reported. This impact on profitability is the reason why the level of aggregation in IFRS 17 is at the center of an industry debate.
This paper summarizes the aggregation requirements of the IFRS 17 standard from various perspectives, including size of groups, trend information that can be extracted from groups, degree of profitability, level of aggregation of cash flows and of CSM calculations, and risk sharing. It also includes comments from EFRAG(2018) in terms of comparing the standard to industry practices, and issues raised with the level of aggregation requirements. This document also addresses the elements that an insurance company must consider to design its own IFRS 17 grouping methodology.
Summary of requirements
The objectives of IFRS 17’s requirements for the level of aggregation are:
»» Identify groups of onerous contracts as soon as possible, rather than obscure them by offsetting their losses with profitable contracts in the larger portfolio of contracts
»» Avoid perpetual open portfolios
»» Allocate CSM appropriately to provide accurate information about profit trends and promote systematic allocation rules over the coverage period
»» Create consistency in profit recognition within the industry
IFRS 17 requires insurers to organize insurance contracts into groups according to three criteria:
1. Product portfolio
2. Degree of profitability
3. Year of issue
Product portfolio means contracts subject to the same risk type and managed together as a single pool. For example, contracts in the same product line – like whole life insurance, annuities, or car insurance – are expected to belong to the same portfolio.
Contracts also must be classified into groups according to the degree of profitability at initial recognition using the following criteria:
A. Groups of contracts that are onerous at initial recognition
B. Groups of contracts that at initial recognition have no significant possibility of becoming onerous
C. Groups of remaining contracts
One of the most challenging aspects of the IFRS 17 standard, is that it requires separate reporting of onerous groups from profitable groups, which impacts when the entity must reveal these onerous groups and their total liability. If the onerous nature were revealed only by portfolio, a downward trend would likely not emerge quickly.
Groups of contracts meeting the various profitability criteria must be further split into ‘cohorts’ or ‘time buckets’ that represent an issuing period of one year or less; for example, insurance contracts issued between 22 April 20X0 and 21 April 20X1 would be split from those issued earlier or later. The rationale for the division into annual cohorts or less is that economic circumstances may change, profitability may change, or the insurer may modify the pricing of the contract. This enables identification of profitability trends and their disclosure in the financial statements. This split into time buckets, often
referred to as the ‘annual cohort’ requirement, can also refer to shorter time periods, for example quarterly cohorts.
Groups are established at initial recognition and are not reassessed or modified subsequently during the coverage period. The following figure summarizes the three criteria assuming annual cohorts:
Size of the group and trend information
The definition of cohorts has an important role in the release of CSM to insurance revenue, since the size of the cohort will indirectly determine the amount of CSM released into revenue over time. The amount of CSM released within each reporting period is based on an average CSM per coverage unit for the group. This reflects the ratio of the service provided during the coverage period to the total projected future service until the last contract of the group matures.
For example, imagine a group with one contract with a total CSM of 100€ and contract duration of five years. If the contract represents five coverage units, the CSM will be released evenly, at a rate of 20€ each year over the coverage period1.
By adding new contracts issued each year, from year 2-6, with duration five years and one coverage unit a year, you can introduce annual cohorts that help to identify trends in profitability associated with consecutive cohorts.
The preceding table represents the overall CSM roll-forward, with in force business in gray and new business in no color. The following trend information can be detected:
a. When considering individual contracts, there is a downward trend in the profitability of new contracts. For example, Contract 1 with an annual CSM release of 20 € terminates in year 6, and from that moment onward the annual CSM becomes 16€; this trend continues over the following years. Among newly written contracts, there is also the downward trend from Year 1 to Year 4, when annual CSM goes from 20 to 8. This trend is reversed starting in Year 5, when annualCSM increases from 8 to 16.
b. When considering the overall CSM released per coverage unit, we can observe a downward trend form Year 1 to Year 6, and a reversal starting in Year 8.
Without annual cohorts, and with a higher level of aggregation, the trends described in point a) would not be identified and the only information extracted from the CSM release would be trend b).